This is helpful in analyzing a single company over a period of time and can be used when comparing similar companies. This could lead to financial difficulties if the company’s earnings start to decline especially because it has less equity to cushion the blow. A good D/E ratio of one industry may be a bad ratio in another and vice versa.
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The D/E ratio is a powerful indicator of a company’s financial stability and risk profile. It reflects the relative proportions of debt and equity a company uses to finance its assets and operations. 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. This second classification of short-term debt is carved out of long-term debt and is reclassified as a current liability called current portion of long-term debt (or a similar name). The remaining long-term debt is used in the numerator of the long-term-debt-to-equity 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.
Specific to Industries
The concept of a “good” D/E ratio is subjective and can vary significantly from one industry to another. Industries that are capital-intensive, such as utilities and manufacturing, often have higher average ratios due to the nature of their operations and the substantial amount of capital required. Therefore, accounting and bookkeeping articles to help grow your business it is essential to align the ratio with the industry averages and the company’s financial strategy. A business that ignores debt financing entirely may be neglecting important growth opportunities.
How do companies improve their debt-to-equity ratio?
The ratio looks at debt in relation to equity, providing insights into how much debt a company is using to finance its operations. If a company cannot pay the interest and principal on its debts, whether as loans to a bank or in the form of bonds, it can lead to a credit event. The D/E ratio is one way to look for red flags that a company is in trouble in this respect. A lower D/E ratio suggests the opposite – that the company is using less debt and is funded more by shareholder equity. This calculation gives you the proportion of how much debt the company is using to finance its business operations compared to how much equity is being used.
What Is a Good Debt-to-Equity (D/E) Ratio?
- The D/E ratio indicates how reliant a company is on debt to finance its operations.
- From Year 1 to Year 5, the D/E ratio increases each year until reaching 1.0x in the final projection period.
- It suggests a conservative financial approach with a strong reliance on equity financing and minimal debt, reducing financial risk.
For instance, a company with $200,000 in cash and marketable securities, and $50,000 in liabilities, has a cash ratio of 4.00. This means that the company can use this cash to pay off its debts or use it for other purposes. The cash ratio compares the cash and other liquid assets of a company to its current liability. This method is stricter and more conservative since it only measures cash and cash equivalents and other liquid assets. If the company is aggressively expanding its operations and taking on more debt to finance its growth, the D/E ratio will be high.
While not a regular occurrence, it is possible for a company to have a negative D/E ratio, which means the company’s shareholders’ equity balance has turned negative. By contrast, higher D/E ratios imply the company’s operations depend more on debt capital – which means creditors have greater claims on the assets of the company in a liquidation scenario. A debt to equity ratio of 1 would mean that investors and creditors have an equal stake in the business assets.
One limitation of the D/E ratio is that the number does not provide a definitive assessment of a company. In other words, the ratio alone is not enough to assess the entire risk profile. It’s also helpful to analyze the trends of the company’s cash flow from year to year. You can calculate the D/E ratio of any publicly traded company by using just two numbers, which are located on the business’s 10-K filing. However, it’s important to look at the larger picture to understand what this number means for the business.
This could mean that investors don’t want to fund the business operations because the company isn’t performing well. Lack of performance might also be the reason why the company is seeking out extra debt financing. Both ratios, however, encompass all of a business’s assets, including tangible assets such as equipment and inventory and intangible assets such as copyrights and owned brands. Because the total debt to assets ratio includes more of a company’s liabilities, this number is almost always higher than a company’s long-term debt to assets ratio. Acceptable levels of the total debt service ratio range from the mid-30s to the low-40s in percentage terms.
To get a clearer picture and facilitate comparisons, analysts and investors will often modify the D/E ratio. They also assess the D/E ratio in the context of short-term leverage ratios, profitability, and growth expectations. For purposes of simplicity, the liabilities on our balance sheet are only short-term and long-term debt. In our debt-to-equity ratio (D/E) modeling exercise, we’ll forecast a hypothetical company’s balance sheet for five years.
Companies in some industries, such as utilities, consumer staples, and banking, typically have relatively high D/E ratios. As a highly regulated industry making large investments typically at a stable rate of return and generating a steady income stream, utilities borrow heavily and relatively cheaply. 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 Q1 2024, ending Dec. 30, 2023, Apple had total liabilities of $279 billion and total shareholders’ equity of $74 billion.
The debt-to-equity ratio (D/E) is a financial leverage ratio that can be helpful when attempting to understand a company’s economic health and if an investment is worthwhile or not. It is considered to be a gearing ratio that compares the owner’s equity or capital to debt, or funds borrowed by the company. An increase in the D/E ratio can be a sign that a company is taking on too much debt and may not be able to generate enough cash flow to cover its obligations. However, industries may have an increase in the D/E ratio due to the nature of their business.
The D/E ratio can be classified as a leverage ratio (or gearing ratio) that shows the relative amount of debt a company has. As such, it is also a type of solvency ratio, which estimates how well a company can service its long-term debts and other measures of financial leverage obligations. This is in contrast to a liquidity ratio, which considers the ability to meet short-term obligations. In general, a lower D/E ratio is preferred as it indicates less debt on a company’s balance sheet. However, this will also vary depending on the stage of the company’s growth and its industry sector. D/E ratios should always be considered on a relative basis compared to industry peers or to the same company at different points in time.
