What Is the Debt-To-Equity Ratio and How Is It Calculated?

Written By :

Category :


Posted On :

Share This :

The D/E ratio contains some ambiguity because a healthy D/E ratio often falls within a range. It may not always be clear to an investor whether the D/E ratio is, in fact, too high or low. The following D/E ratio calculation is for Restoration Hardware (RH) and is based on its 10-K filing for the financial year ending on January 29, 2022. Over 1.8 million professionals use CFI to learn accounting, financial analysis, modeling and more. Start with a free account to explore 20+ always-free courses and hundreds of finance templates and cheat sheets. Get instant access to video lessons taught by experienced investment bankers.

If a company has a negative debt ratio, this would mean that the company has negative shareholder equity. In most cases, this is considered a very risky sign, indicating that the company may be at risk of bankruptcy. Acceptable levels of the total debt service ratio range from the mid-30s to the low-40s in percentage terms. So if a company has total assets of $100 million and total debt of $30 million, its debt ratio is 0.3 or 30%. Is this company in a better financial situation than one with a debt ratio of 40%? Please refer to Titan’s Program Brochure for important additional information.

What counts as a good debt ratio will depend on the nature of the business and its industry. Generally speaking, a debt-to-equity or debt-to-assets ratio below 1.0 would be seen as relatively safe, whereas ratios of 2.0 or higher would be considered risky. Some industries, such as banking, are known for having much higher debt-to-equity ratios than others. In the consumer lending and mortgage business, two common debt ratios used to assess a borrower’s ability to repay a loan or mortgage are the gross debt service ratio and the total debt service ratio. It’s great to compare debt ratios across companies; however, capital intensity and debt needs vary widely across sectors. The financial health of a firm may not be accurately represented by comparing debt ratios across industries.

  1. Please refer to Titan’s Program Brochure for important additional information.
  2. Certain information contained in here has been obtained from third-party sources.
  3. When assessing D/E, it’s also important to understand the factors affecting the company.
  4. The optimal debt-to-equity ratio will tend to vary widely by industry, but the general consensus is that it should not be above a level of 2.0.

The debt-to-equity ratio calculates if your debt is too much for your company. Investors, stakeholders, lenders, and creditors may look at your debt-to-equity ratio to determine if your business is a high or low risk. The higher the risk, the less likely you are to receive loans or have an investor come on board (which we’ll get into more later). 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. For example, capital-intensive companies such as utilities and manufacturers tend to have higher D/E ratios than other companies.

A good D/E ratio also varies across industries since some companies require more debt to finance their operations than others. A low D/E ratio shows a lower amount of financing by debt from lenders compared to the funding by equity from shareholders. The company who takes advantage of this opportunity will, if all goes as projected, generate an additional $1 billion of operating profit while paying $600 million https://www.wave-accounting.net/ in interest payments. This would add $400 million to the company’s pre-tax profit and should serve to increase the company’s net income and earnings per share. It’s crucial to pair debt-to-equity ratio with other measures like the current ratio, return on equity, and net profit margin. Like the D/E ratio, all other gearing ratios must be examined in the context of the company’s industry and competitors.

When interpreting the D/E ratio, you always need to put it in context by examining the ratios of competitors and assessing a company’s cash flow trends. As an example, many nonfinancial corporate businesses have seen their D/E ratios rise in recent years because they’ve increased their debt considerably over the past decade. Over this period, their debt has increased from about $6.4 billion to $12.5 billion (2). Some investors also like to compare a company’s D/E ratio to the total D/E of the S&P 500, which was approximately 1.58 in late 2020 (1). Restoration Hardware’s cash flow from operating activities has consistently grown over the past three years, suggesting the debt is being put to work and is driving results.

How to Interpret the D/E Ratio?

The formula for calculating the debt-to-equity ratio (D/E) is as follows. Adam Hayes, Ph.D., CFA, is a financial writer with 15+ years Wall Street experience as a derivatives trader. Besides his extensive derivative trading expertise, Adam is an expert in economics and behavioral finance. Adam received his master’s in economics from The New School for Social Research and his Ph.D. from the University of Wisconsin-Madison in sociology. He is a CFA charterholder as well as holding FINRA Series 7, 55 & 63 licenses. He currently researches and teaches economic sociology and the social studies of finance at the Hebrew University in Jerusalem.

This method is stricter and more conservative since it only measures cash and cash equivalents and other liquid assets. Using the D/E ratio to assess a company’s financial leverage may not be accurate if the company has an aggressive growth strategy. 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. The debt capital is given by the lender, who only receives the repayment of capital plus interest. Whereas, equity financing would entail the issuance of new shares to raise capital which dilutes the ownership stake of existing shareholders. A high D/E ratio suggests that the company is sourcing more of its business operations by borrowing money, which may subject the company to potential risks if debt levels are too high.

When calculating the debt to equity ratio, you use the entire $40,000 in the numerator of the equation. Lenders and debt investors prefer lower D/E ratios as that implies there is less reliance on debt financing to fund operations – i.e. working capital requirements such as the purchase of inventory. Industries with high D/E ratios typically include capital-intensive sectors like utilities, real estate, and finance, where substantial debt is common to fund operations and investments. If a company has a negative D/E ratio, this means that it has negative shareholder equity.

Why are D/E ratios so high in the banking sector?

In most cases, this would be considered a sign of high risk and an incentive to seek bankruptcy protection. The concept of comparing total assets to total debt also relates to entities that may not be businesses. For example, the United States Department of Agriculture keeps a close eye on how the relationship between farmland assets, debt, and equity change welcoming accountable voices in education over time. It’s important to keep in mind that the D/E ratio has some limitations. For one, a business’s leverage might be skewed by including or excluding preferred stock, contributions to retirement accounts, and so-called intangible assets. In turn, the ratio might not paint a complete or accurate picture of how much debt a company is actually carrying.

Advantages of Debt Financing

Conversely, a lower ratio indicates a firm less levered and closer to being fully equity financed. However, D/E ratios vary by industry and, therefore, can be misleading if used alone to access a company’s financial health. For this reason, using the D/E ratio along with other leverage ratios and financial information will give you a clearer picture of a firm’s leverage.

Even though shareholder’s equity should be stated on a book value basis, you can substitute market value since book value understates the value of the equity. Market value is what an investor would pay for one share of the firm’s stock. For purposes of simplicity, the liabilities on our balance sheet are only short-term and long-term debt.

The 10-K filing for Ethan Allen, in thousands, lists total liabilities as $312,572 and total shareholders’ equity as $407,323, which results in a D/E ratio of 0.76. Put another way, if a company was liquidated and all of its debts were paid off, the remaining cash would be the total shareholders’ equity. For growing companies, the D/E ratio indicates how much of the company’s growth is fueled by debt, which investors can then use as a risk measurement tool. The debt-to-equity (D/E) ratio is a metric that shows how much debt, relative to equity, a company is using to finance its operations. If a company has a D/E ratio of 5, but the industry average is 7, this may not be an indicator of poor corporate management or economic risk.

What is a Good Debt to Equity Ratio?

Learn financial statement modeling, DCF, M&A, LBO, Comps and Excel shortcuts. From Year 1 to Year 5, the D/E ratio increases each year until reaching 1.0x in the final projection period. Upon plugging those figures into our formula, the implied D/E ratio is 2.0x. In addition, you can also choose to invest in exchange-traded funds (ETFs) or stocks via smallcase where you will pre-packaged portfolios according to your budget and risk appetite.

The term “ratio” in DE ratio refers to the comparison of two financial metrics and is expressed as a single numerical value, which is DE ratio. Information provided by Titan Support is for informational and general educational purposes only and is not investment or financial advice. Stay informed on the most impactful business and financial news with analysis from our team. This ratio is typically expressed in numerical form, such as 0.6, 1.2, or 2.0.

Brokerage services are provided to Titan Clients by Titan Global Technologies LLC and Apex Clearing Corporation, both registered broker-dealers and members of FINRA/SIPC. You may check the background of these firms by visiting FINRA’s BrokerCheck. A high debt-to-equity ratio generally means a company is using more borrowing to finance its operations, implying greater risk. This is common in startups or fast-growing businesses, where substantial risk can come with high potential rewards. In contrast, sectors like utilities or manufacturing, which require significant investment, regularly exhibit higher ratios. A company’s total debt is the sum of short-term debt, long-term debt, and other fixed payment obligations (such as capital leases) of a business that are incurred while under normal operating cycles.