What is the ‘Debt/Equity Ratio’
Debt/Equity (D/E) Ratio, calculated by dividing a company’s total liabilities by its stockholders’ equity, is a debt ratio used to measure a company’s financial leverage. The D/E ratio indicates how much debt a company is using to finance its assets relative to the value of shareholders’ equity. The formula for calculating D/E ratios is:
Debt/Equity Ratio = Total Liabilities / Shareholders’ Equity
The result can be expressed either as a number or as a percentage.
The debt/equity ratio is also referred to as a risk or gearing ratio.
BREAKING DOWN ‘Debt/Equity Ratio’
Debt/Equity Ratio for Corporate Fundamental Analysis
Given that the debt/equity ratio measures a company’s debt relative to the total value of its stock, it is most often used to gauge the extent to which a company is taking on debt as a means of leveraging (attempting to increase its value by using borrowed money to fund various projects). A high debt/equity ratio generally means that a company has been aggressive in financing its growth with debt. Aggressive leveraging practices are often associated with high levels of risk. This may result in volatile earnings as a result of the additional interest expense.
For example, utility company Dominion Energy (NYSE:D), in its fiscal year ended 2016, listed its total liabilities as $54.77 billion and total shareholders’ equity as $14.61 billion. It’s D/E ratio is, therefore, $54.77 / $14.61 = 3.75, or 375%. For the same fiscal year, Alphabet, Inc. (Nasdaq:GOOG) recorded total liabilities of $27.13 billion and total equity of $120.33 billion. It’s D/E ratio is $27.13 / $120.33 = 0.2255, or 22.55%. The ratios of both companies indicate that Dominion is taking on more debt than Alphabet relative to the equity value.
If a lot of debt is used to finance increased operations (high debt to equity), the company could potentially generate more earnings than it would have without this outside financing. If this were to increase earnings by a greater amount than the debt cost (interest), then the shareholders benefit as more earnings are being spread among the same number of shareholders. However, if the cost of debt financing ends up outweighing the returns that the company generates on the debt through investment and business activities, stakeholders’ share values may take a hit. If the cost of debt becomes too much for the company to handle, it can even lead to bankruptcy, which could leave shareholders with nothing since creditors are paid first during liquidation proceedings.
Debt/Equity Ratio for Personal Finances
The Debt/Equity (D/E) ratio can be applied to personal financial statements as well, in which case it is also known as the Personal Debt/Equity Ratio. Here, “equity” refers not to the value of stakeholders’ shares but rather to the difference between the total value of an individual’s assets and the total value of his or her debt or liabilities. The formula for the personal D/E ratio, then, can be represented as:
D/E = Total Personal Debt / (Total Assets – Total Personal Debt)
The personal debt/equity ratio is often used in financing, as when an individual or small business is applying for a loan. This form of D/E essentially measures the dollar amount of debt an individual has for each dollar of equity they have. D/E is very important to a lender when considering a candidate for a loan, as it can greatly contribute to the lender’s confidence (or lack thereof) in the candidate’s financial stability.
A candidate with a high personal debt/equity ratio has a high amount of debt relative to their available equity, and will not likely instill much confidence in the lender that the candidate can repay the loan. On the other hand, a candidate with a low personal debt/equity ratio has relatively low debt, and thus poses much less risk to the lender, as the candidate would appear to have a reasonable ability to repay the loan.
Limitations of Debt/Equity Ratio
As with most ratios, when using the debt/equity ratio, it is very important to consider the industry in which the company operates. Because different industries rely on different amounts of capital to operate, and use that capital in different ways, a relatively high D/E ratio may be common in one industry while a relatively low D/E may be common in another. For example, capital-intensive industries such as auto manufacturing tend to have a debt/equity ratio above 2, while companies like personal computer manufacturers usually are not particularly capital intensive and may often have a debt/equity ratio of under 0.5. As such, D/E ratios should only be used to compare companies that operate within the same industry.
Another important point to consider when assessing D/E ratios is that the “Total Liabilities” portion of the formula may often be determined in a variety of ways by different companies, some of which are not actually the sum of all of the company’s liabilities. In some cases, companies will only incorporate debts, such as loans and debt securities, into the liabilities portion of the formula, while omitting other kinds of liabilities, such as unearned revenue. In other cases, companies may calculate D/E in an even more specific way, including only long-term debts and excluding short-term debts and other liabilities. Yet, “long-term debt” here is not necessarily a term with a consistent meaning. It may include all long-term debts, but it may also exclude long-term debts nearing maturity, which are then categorized as “short-term” debts. Because of these differentiations, one should try to determine how the ratio was calculated and should be sure to consider other ratios and performance metrics as well when considering using a company’s debt/equity ratio for investment decisions.