A comprehensive guide to the debt-to-equity ratio: Definition, formula and analysis

It takes money to make money, we know, but there are different ways a public company can access dollars to finance an expansion. Sometimes a business may use earnings or shareholders’ equity to fund growth, but it may also turn to debt, in the form of loans, to provide flexibility and predictability around the cost of capital.

Of course, there are two sides to every financing story, and too much debt can weigh on a business and ultimately impact its stock price. That’s why investors should have a sense of a company’s financial position before investing. One of the simplest ways to get a snapshot of a company’s level of indebtedness is the debt-to-equity ratio.

What is the debt-to-equity ratio?

The debt-to-equity ratio is a popular metric that provides a view into how much debt a company has taken on. The ratio divides the company’s total equity, or shareholder ownership in a company, less any debts and other liabilities, by its total debt. A company with a lot of debt may have a high debt-to-equity ratio and one with little leverage, a low one.

Importance of the debt-to-equity ratio for investors

In the same way a person can land in trouble if they take on more debt than they can afford, a company can find itself in hot water if it’s overleveraged. If a business has too much debt, it may not have enough cash to fund growth or pay dividends. If it can’t make its payments, it could file for bankruptcy — potentially leaving equity holders with nothing.

Generally speaking, companies with a high debt-to-equity ratio may be at a greater financial risk than those with a low one, and this can affect how attractive their stock is to investors. The ratio is most meaningful when comparing two or more stocks in the same industry and growth stage. While it’s a useful measure of financial health, it’s just one of several ratios you may consider before investing in a company.

How is the debt-to-equity ratio calculated?

The figures needed to calculate the debt-to-equity ratio can be found on the company’s latest balance sheet — sometimes called a statement of financial position or statement of assets and liabilities. The sum of all short-term and long-term debt (plus, if applicable, the current portion of long-term debt) is divided by the sum of all share capital and retained earnings. Expressed as an equation, it looks like this:

Debt-to-equity ratio = Total liabilities / Shareholders' equity

Many investing apps and websites will calculate a stock’s debt-to-equity ratio for you, but it’s best to double-check using the company's balance sheet if you are considering investing. There may be anomalies that are not readily accounted for using this formula.

Types of debt and equity

Debt represents bank financing, such as lines of credit and term loans shorter than one year, plus longer-term corporate loans and mortgages and corporate bonds issued to investors.

The equity portion of the ratio represents share capital — money raised from the sale of shares to investors, combined with retained earnings or the profit left over after covering all costs, including taxes.

How should I interpret the debt-to-equity ratio?

Finding a stock with a high debt-to-equity ratio compared to its peers could be a red flag, but not always. Here are a few ways to interpret that figure.

What is a good or bad debt-to-equity ratio?

When comparing two similar stocks, the one with the higher ratio may come with higher financial risk due to its increased debt load. For example, all things being equal, if Company A has a debt-to-equity ratio of 1.0 and Company B, a ratio of 2.0, Company B may be seen as riskier as it would have higher fixed financing charges that can reduce the cash flow available for earnings and dividends. In times of recession or high interest rates, companies carrying high levels of debt can also run a greater risk of insolvency. Debt can also be a good thing, as long as the company can pay off its loans. For instance, many companies borrow money to finance expansions, which can result in more revenue and earnings down the road.

What are the factors that affect the debt-to-equity ratio?

A company can change its debt-to-equity ratio, for example, by borrowing new money to complete an acquisition or by divesting an asset for cash. A company may also prioritize paying down debt with cash over investing in new capacity, boosting the dividend or buying back shares.

How can investors use the debt-to-equity ratio?

On its own, the debt-to-equity ratio may not be an especially useful tool for evaluating investments. That’s why it’s often used in combination with other metrics that track factors like earnings growth, value and momentum. Say you are a value investor and you like stocks with low price-to-earnings ratios. When you identify a stock with an attractive price-to-earnings ratio, you may also look at its debt-to-equity ratio. If it’s higher than those of rivals in the same industry, that may explain why the company is relatively undervalued. If the debt-to-equity ratio is in line with its peers, however, you may make a stronger case that the stock is a “buy.”

How does debt-to-equity compare with other ratios?

The debt-to-equity ratio is a high-elevation snapshot of a company’s financial position, but there are other liquidity measures, like the current ratio and the quick ratio, that can zero in on a company’s capacity to handle a short-term crisis.

• Current ratio: The current ratio indicates the firm’s ability to pay its current obligations from current assets (current assets to liabilities). Generally, a current ratio of 2.0 is considered to be good.
• Quick ratio: The quick ratio is similar, but more onerous, as it excludes inventory from current assets.

Modifying the debt-to-equity ratio

Financial analysts sometimes customize the debt-to-equity ratio to reflect other factors that are unique to the stock or the sector. For example, they may include total liabilities, which could include other amounts owing, such as tax, in the numerator. Total equity can also be determined by subtracting total liabilities from total assets. Whatever method you prefer, it’s important to use the same equation for all the companies being compared.

Alternatives to the debt-to-equity ratio

Sometimes the debt-to-equity ratio does not produce a useful number for comparison. In that case, there may be other calculations you can apply:

Debt ratio:

The debt ratio compares debt to assets to show how much of a company’s assets are financed with debt.

Equity multiplier:

The equity multiplier, also known as the leverage ratio, is calculated by dividing total assets by total equity. A high number means the company is primarily debt-financed, while a low number means it is largely financed by shareholder equity.

Times interest earned (TIE) ratio:

The TIE ratio, or the interest coverage ratio, takes a company’s earnings before interest and taxes (EBIT) and divides it by the interest charges on bonds and other debt. It measures the degree to which pre-tax earnings will cover debt servicing costs.

Benefits and limitations of a high debt-to-equity ratio

Certain types of businesses will naturally have high debt-to-equity ratios, including utilities, financial institutions and real estate investment trusts. These businesses rely heavily on debt to build and maintain infrastructure, support lending businesses or acquire land and buildings. As a result, they typically have ratios that might otherwise indicate trouble in other sectors. The businesses may be able to support their heightened debt levels. thanks to regulated revenues and the enduring value of their assets. This is why the debt-to-equity ratio may be most helpful when comparing companies in the same industry.

What other financial ratios should be used in conjunction with the debt-to-equity ratio?

The debt-to-equity ratio can be useful in conducting due diligence on stocks that look attractive based on their earnings growth, value, dividend growth and momentum. It can also provide an opposing view on stocks that look attractive using other metrics, such as price-to-earnings, price-to-book value, dividend yield and compound annual growth rate.

What are considerable versus non-considerable debts?

A company may be seen as having considerable debt when it has 10 or more debts owing to a single lender. This can be a sign of financial distress. Non-considerable debts are more widely dispersed and less of a concern for investors.

What is short-term versus long-term debt?

In financial statements, debt is usually categorized as either short term or long term. Short-term debt represents bank financing, such as lines of credit or term loans maturing in less than one year. Long-term debt represents structured loans such as corporate term loans and mortgages, as well as corporate bonds issued to investors. When interest rates rise, it affects short-term debt first.

Frequently Asked Questions

What does a debt-to-equity ratio of 1.5 mean?

It means the company’s debt exceeds the value of its total equity by 50%, which may indicate that the company finances its operations with significant debt.

What is a good debt-to-equity ratio?

It depends on the industry the company operates in and its growth stage. Mature retailers, for example, may have a debt-to-equity ratio below 1.0. However, a bank, utility or real estate investment trust may easily be able to support a debt-to-equity ratio of 2.0

Is a higher debt-to-equity ratio better?

It depends on the industry and the company, generally, no. It indicates the company could be at risk of insolvency when faced with a shock.

Is a high debt-to-equity ratio good or bad?

A company that has a higher debt-to-equity ratio than comparable firms may be considered a weaker investment choice when other metrics are also taken into consideration.

Is the debt-to-equity ratio widely used by banks?

Banks typically use the debt-to-equity ratio when considering whether to lend to a company. It helps them determine whether the company is able to take on more debt.

To what extent does a company rely on debt?

It depends on the industry. Financial and real estate companies often borrow more than twice the amount raised from investors. In other sectors, debt-to-equity ratios will typically be below 1.0.

Can a company have a negative debt-to-equity ratio?

Yes, when the interest on its debts exceeds its return on investment. The situation usually requires restructuring of the company or its debt commitments.

What does a high or low debt-to-equity ratio signify?

A high debt-to-equity ratio suggests a company carries higher risk than others with a lower ratio. A low ratio can suggests financial stability and resilience.

Can a company have too much equity and not enough debt?

Yes. Over-reliance on equity to fund company operations can be costly and inefficient and can sometimes make the company the target of a leveraged buyout.

How often should a company evaluate its debt-to-equity ratio?

The debt-to-equity ratio is one of many metrics managers should regularly monitor to ensure they remain attractive to lenders and equity investors.

Think of the debt-to-equity ratio as providing you with a sober second thought on an investment you're excited about.