The debt to equity ratio can be misleading unless it is used along with industry average ratios and financial information to determine how the company is using debt and equity as compared to its industry. Companies that are heavily capital intensive may have higher debt to equity ratios while service firms will have lower ratios. Debt-to-equity is a gearing ratio comparing a company’s liabilities to its shareholder equity. Typical debt-to-equity ratios vary by industry, but companies often will borrow amounts that exceed their total equity in order to fuel growth, which can help maximize profits.
- Airlines, as well as oil and gas refinement companies, are also capital-intensive and also usually have high D/E ratios.
- Debt-to-equity (D/E) ratio is used to evaluate a company’s financial leverage and is calculated by dividing a company’s total liabilities by its shareholder equity.
- As an example, the furnishings company Ethan Allen (ETD) is a competitor to Restoration Hardware.
- Its D/E ratio would therefore be $1.2 million divided by $800,000, or 1.5.
- The opposite of the above example applies if a company has a D/E ratio that’s too high.
In most cases, this would be considered a sign of high risk and an incentive to seek bankruptcy protection. Other definitions of debt to equity may not respect this accounting identity, and should be carefully compared. Generally speaking, a high ratio may indicate that the company is much resourced with (outside) borrowing as compared to funding from shareholders.
Because different industries have different capital needs and growth rates, a D/E ratio value that’s common in one industry might be a red flag in another. Gearing ratios focus more heavily on the concept of leverage than other ratios used in accounting or investment analysis. The underlying principle generally assumes that some leverage is good, but that too much places an organization at risk. However, in this situation, the company is not putting all that cash to work.
Debt to Equity Ratio Calculation Example (D/E)
High leverage ratios in slow-growth industries with stable income represent an efficient use of capital. Companies in the consumer staples sector tend to have high D/E ratios for similar reasons. We can see below that for the fiscal year (FY) ended 2017, Apple had total liabilities of $241 billion (rounded) and total shareholders’ equity of $134 billion, according to the company’s 10-K statement. Another popular iteration of the ratio is the long-term-debt-to-equity ratio which uses only long-term debt in the numerator instead of total debt or total liabilities.
By using debt instead of equity, the equity account is smaller and therefore, return on equity is higher. However, a low D/E ratio is not necessarily a positive sign, as the company could be relying too much on equity financing, which is costlier than debt. The D/E ratio represents the proportion of financing that came from creditors (debt) versus shareholders (equity). When using D/E ratio, it is very important to consider the industry in which the company operates.
Interpreting the D/E ratio requires some industry knowledge
If the debt to equity ratio is less than 1.0, then the firm is generally less risky than firms whose debt to equity ratio is greater than 1.0.. A company’s debt is its long-term debt such as loans with a maturity of greater than one year. Equity is shareholder’s equity or what the investors in your business own. If your business is a small business that is a sole proprietorship and you are the only owner, your investment in the business would be the shareholder’s equity.
As noted above, the numbers you’ll need are located on a company’s balance sheet. Total liabilities are all of the debts the company owes to any outside entity. Determining whether a company’s ratio is good or bad means considering other factors in conjunction with the ratio. Liabilities are items or money the company owes, such as mortgages, loans, etc.
D/E Ratio vs. Gearing Ratio
The debt-to-equity ratio divides total liabilities by total shareholders’ equity, revealing the amount of leverage a company is using to finance its operations. As with any ratio, the debt-to-equity ratio offers more meaning and insight when compared to the same calculation for different historical financial periods. If a company’s debt to equity ratio has risen dramatically over time, the company may have an aggressive growth strategy being funded by debt. The debt to equity ratio shows a company’s debt as a percentage of its shareholder’s equity.
How to Calculate D/E Ratio in Excel
A company with a D/E ratio that exceeds its industry average might be unappealing to lenders or investors turned off by the risk. As well, companies with D/E ratios lower than their industry average might be seen as favorable to lenders and investors. Because debt is inherently risky, lenders and investors tend to favor businesses with lower D/E ratios.
Formula
Banks often have high D/E ratios because they borrow capital, which they loan to customers. They may note that the company has a high D/E ratio and conclude that the risk is too high. For this reason, it’s important to understand the norms for the industries you’re looking to invest in, and, as above, dig into the larger context when assessing the D/E ratio.
However, if that cash flow were to falter, Restoration Hardware may struggle to pay its debt. This figure means that for every dollar in equity, Restoration Hardware has $3.73 in debt. On the other hand, a comparatively low D/E ratio may indicate that the company is not taking full advantage of the growth that can be accessed via debt. Simply put, the higher the D/E ratio, the more a company relies on debt to sustain itself.
