What the D/E Ratio Tells Us About a Company
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Jean Folger has 15+ years of experience as a financial writer covering real estate, investing, active trading, the economy, and retirement planning. She is the co-founder of PowerZone Trading, a company that has provided programming, consulting, and strategy development services to active traders and investors since 2004.
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Updated October 03, 2021
Fact checked byKirsten Rohrs Schmitt
What Is a High Debt-to-Equity Ratio?
The debt-to-equity (D/E) ratio is a metric that provides insight into a company's use of debt. In general, a company with a high D/E ratio is considered a higher risk to lenders and investors because it suggests that the company is financing a significant amount of its potential growth through borrowing. What is considered a high ratio can depend on a variety of factors, including the company's industry.
Key Takeaways:
- The debt-to-equity (D/E) ratio reflects a company's debt status.
- A high D/E ratio is considered risky for lenders and investors because it suggests that the company is financing a significant amount of its potential growth through borrowing.
- Whether a D/E ratio is high or not depends on many factors, such as the company's industry.
Understanding the Debt-to-Equity (D/E) Ratio
The D/E ratio relates the amount of a firm’sdebt financingto its equity. To calculate the D/E ratio, divide a firm's total liabilities by its total shareholder equity—both items are found on a company's balance sheet. The company’s capital structure is the driver of the debt-to-equity ratio. The more debt a company uses, the higher the debt-to-equity ratio will be.
Debt typically has a lower cost of capital compared to equity, mainly because of its seniority in the case of liquidation. Thus, many companies may prefer to use debt over equity for capital financing. In some cases, the debt-to-equity calculation may be limited to include only short-term and long-term debt. Most often, it also includes some form of additional fixed payments. Together, the total debt and total equity of a company combine to equal its total capital, which is also accounted for as total assets.
Analyzing the Debt-to-Equity (D/E) Ratio by Industry
As is typical in financial analysis, a single ratio, or a line item, is not viewed in isolation. Therefore, the D/E ratio is typically considered along with a few other variables. One of the main starting points for analyzing a D/E ratio is to compare it to other company's D/E ratios in the same industry. Overall, D/E ratios will differ depending on the industry because some industries tend to use more debt financing than others. In the financial industry, for example, the D/E ratio tends to be higher than in other sectors because banks and otherfinancial institutionsborrow money to lend money, which can result in a higher level of debt.
Other industries that tend to have large capital project investments also tend to be characterized by higher D/E ratios. These industries can include utilities, transportation, and energy.
Special Considerations for the Analysis of D/E Ratios
A popular variable for consideration when analyzing a company’s D/E ratio is its own historical average. A company may be at or below the industry average but above its own historical average, which can be a cause for concern. In this case, it is important to analyze the company’s current situation and the reasons for the additional debt.
The weighted average cost of capital (WACC) can provide insight into the variability of a company’s D/E ratio. The WACC shows the amount of interest financing on the average per dollar of capital. The equation also breaks down the average payout for debt and equity.
If a company has a low average debt payout, this implies that the company is obtaining financing in the market at a relatively low rate of interest. This advantage can make the use of debt more attractive, even if the D/E ratio is higher than comparable companies.
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Now, let's delve into the concepts discussed in the article "What the D/E Ratio Tells Us About a Company" by Jean Folger.
Debt-to-Equity (D/E) Ratio: The debt-to-equity ratio is a crucial financial metric that offers valuable insights into a company's financial structure and risk. It is a ratio that relates a firm's debt financing to its equity. Specifically, the D/E ratio is calculated by dividing a company's total liabilities by its total shareholder equity, both of which can be found on the company's balance sheet.
Significance of D/E Ratio: A high D/E ratio indicates that a company is relying heavily on debt to finance its operations and potential growth. This heightened reliance on borrowing is perceived as a higher risk by both lenders and investors. The reasoning behind this concern lies in the fact that excessive debt increases the financial vulnerability of a company, especially during economic downturns.
Determinants of D/E Ratio: The company's capital structure is a key driver of the debt-to-equity ratio. The more a company utilizes debt in its capital structure, the higher its D/E ratio will be. It's noteworthy that debt often comes with a lower cost of capital compared to equity, making it an attractive option for financing.
Industry Variations: The assessment of whether a D/E ratio is high or not should take into account the industry in which the company operates. Different industries have varying levels of tolerance for debt. For instance, the financial industry, including banks, tends to have higher D/E ratios due to their business model of borrowing to lend. Similarly, industries with significant capital projects, such as utilities, transportation, and energy, often exhibit higher D/E ratios.
Comparative Analysis: Financial analysts rarely interpret the D/E ratio in isolation. Instead, it is typically evaluated alongside other variables. A crucial aspect of this comparative analysis is benchmarking the D/E ratio against other companies within the same industry. A company's D/E ratio may be considered acceptable if it aligns with the industry norm, but diverging from its historical average could be a cause for concern.
Historical Perspective and WACC: Considering a company's historical D/E ratio is essential for a comprehensive analysis. If a company is operating above its historical average, it raises questions about the reasons behind the shift. Additionally, the Weighted Average Cost of Capital (WACC) is a valuable tool that sheds light on the overall cost of financing for a company. A low average debt payout in the WACC equation suggests that the company is obtaining financing at a relatively low rate of interest, making the use of debt more attractive despite a higher D/E ratio compared to peers.
In summary, a nuanced understanding of the debt-to-equity ratio involves considering industry benchmarks, historical trends, and the overall capital structure of a company. This multifaceted analysis is crucial for accurately assessing a company's financial health and risk profile.
