Debt-to-Equity (D/E) Ratio Definition with Formula

Tally Solutions | Updated on: July 20, 2022

• What is the debt-to-equity ratio?
• Debt-to-equity ratio formula and calculation
• What does the debt-to-equity ratio tell you?
• What is a good debt-to-equity ratio?
• Modifications to the debt-to-equity ratio
• Limitations of the debt-to-equity ratio
• Examples of the debt-to-equity ratio
• What does a debt-to-equity ratio of 1.5 indicate?
• What does it mean for debt-to-equity to be negative?
• What industries have high debt-to-equity ratios?

There are many methods used to assess and mathematically analyze the financial health of a company. The debt to equity ratio (D/E ratio) is one of the metrics that is used to determine if the company has a normal level of debt compared to equity. If the D/E is healthy, investors can be assured that the company is not deeply into debt. But if the ratio is high, it may indicate an over-reliance on debt and a difficulty in repayment. This may signal to potential investors that the company is in a risky situation and may run into a problem meeting its obligations or even staying afloat in the near future.

What is the debt-to-equity (D/E) ratio?

A company can finance itself through two methods; equity and debt. The more equity investment there is, the better the ability of the company to meet its commitments without raising debt. The debt-to-equity (D/E) ratio literally compares the company’s equity with the amount of debt that it is carrying to assess the financial leverage that it is using. In corporate finance, the D/E metric is used to determine if the equity the company holds will be able to cover the outstanding debts in case the company faces any unforeseen adverse event or situation.

If the D/E ratio is higher than the industry average, it indicates that the company is a high risk for investment and for its shareholders. It must be kept in mind that certain industries have a very high D/E ratio and that this metric is a good comparison within the same industry and not across industries. There is also a different risk for long-term vs short-term liabilities. Investors sometimes modify the D/E ratio to better reflect the difference between short and long-term liability risk.

Debt-to-equity (D/E) ratio formula and calculation

​The D/E ratio is a comparison of the company’s equity and its total liabilities. It is calculated with the following formula:

Debt/Equity= Total Liabilities / Shareholders’ Total Equity

​The information about the company’s total liabilities and the shareholder’s equity can be found on the balance sheet. The balance sheet usually states assets as the shareholder’s equity added to the total liabilities. It must be noted that some of the accounts that the balance sheet considered as assets or liabilities may not be applicable for use in the D/E ratio. Some of these accounts are intangible assets, retained losses, retained earnings, etc. One must identify the assets and liabilities that are to be used for the D/E calculation purposes individually.

Some analysts and investors further modify the debt to equity ratio to reflect these ambiguities in the balance sheet categories and to also account for short-term leverage, performance, and expectation of growth of the company. This gives a complete picture of the company’s leverage.​

What does the debt-to-equity (D/E) ratio tell you?

The D/E ratio tells you how the company is sourcing money for its operations. By comparing the company’s debt to its assets, it assesses how much the company is leveraging its assets to raise debt. A company may look promising because of its rapid growth and expansion spurt. But, the D/E ratio may reveal that this sudden growth has been financed by taking on huge amounts of debt.

While it may be true that the expansion will also boost the company’s earning potential, one must also monitor the cost of the debt. But, if the extra income does not adequately cover the cost of the debt, the company may face a downturn. Though the repercussions of taking on expensive debt may not be clear at first, it will have an impact over time. This may result in a fall in the share value.

Long-term debts have a larger impact on the D/E simply because these debts are usually larger. For an accurate estimation of the short-term leverage used by a company, analysts must use other metrics such as the cash ratio. For example, an investor who needs to compare a company’s short-term liquidity or solvency will use the cash ratio:

Cash Ratio= (Cash + Marketable Securities) / Short Term Liabilities

The current ratio is also a very useful calculation for short-term leverage analysis.

Current Ratio = Short Term Assets / Short Term Liabilities

The cash ratio and current ratio give a more accurate understanding of short-term leverage than the D/E ratio, which is to be used only for a long-term analysis.

What is a good debt-to-equity (D/E) ratio?

There is significant variation in the D/E ratio between industries. So, the definition of a generic ‘good’ D/E ratio is not possible. In a very general sense, a D/E ratio of 1 would be considered to be safe as the equity and the debts balance out. However, a ratio of 2 and above would be considered risky in most industries. However, by nature, verticals such as banking would have a much higher D/E ratio. An abnormally low D/E ratio shows that the company is missing out on opportunities to access debt financing to fuel its growth.

Modifications to the debt-to-equity (D/E) ratio

One cannot use the numbers on the balance sheet directly to calculate the D/E ratio. This is because, by definition, equity is the assets minus the related debt. So, an analyst must be careful to take only the relevant data from the balance sheet to compute the D/E ratio properly and accurately. This calculation can be modified into the long-term debt to equity ratio by selectively choosing the numbers used.

Short-term debts are not considered in these calculations because they are relatively low risk. Since short-term debts are usually settled in less than a year they do not have a very significant role in the company’s long-term finances. For example, we can compare companies A and B

If we calculate the D/E ratio for both the companies, it will be equal. But when we analyze the short-term debt vs. the long-term debt, we see that Company A has a larger long-term debt and is riskier than Company B. This illustrates the importance of disregarding short-term debt when calculating the D/E ratio for a company.

The interest rates for debt change according to market conditions. Generally, short-term debt is cheaper than long-term debt. So a company with more long-term debt will also have a larger interest expense.

Limitations of the debt-to-equity (D/E) ratio

Another factor to be kept in mind is that what is considered a normal D/E ratio differs by industry. While some industries have high D/E ratios as the norm, lower ratios may be normal in other industries. It is common to see that utility companies have very high D/E ratios and this is not usually a problem as these companies are very stable and have slow growth combined with steady incomes. So a high debt to equity ratio in such a company would not be risky. The consumer staples industry also has a high debt to equity ratio as they have a stable income and can access debt at cheaper rates.

Another limitation of D/E is that there is no consistency among analysts in what they classify as debt for the calculation of D/E. While the preferred stock may be classified as equity, the par value, preferred dividend, and liquidation rights are more like debt. Preferred stock classified as debt inflated the D/E ratio and the company appears to be riskier. But, if it is included in equity, it lowers the ratio. So there is no uniformity in the calculation of D/E.

Examples of the debt-to-equity (D/E) ratio

We can take the example of two companies. Company A has total shareholder equity of IDR9 billion and total liabilities of IDR14 billion, and a debt to equity ratio of 1.5. Another company B has shareholder equity of IDR30 billion and total liabilities of IDR40 billion. The D/E ratio is 1.3. The analysts comparing the two companies may think that since Company A has a higher D/E ratio, it has a higher risk. But after looking at the data more deeply, it is seen that the preferred stock has not been included in the equity. The reclassification of the preferred stock lowers the D/E ratio, and the company appears more attractive.

What does a debt-to-equity (D/E) ratio of 1.5 indicate?

Even without knowing the metrics that were used to calculate the debt to equity ratio, we can determine that the company with a D/E ratio of 1.5 has 1.5 times more debt than equity. In other words, it has IDR1.5 debt for every $1 of equity. So, if the equity were $1 million, the debt would be IDR1.5 million.

What does it mean for D/E to be negative?

A negative D/E ratio means that the shareholder equity that was used to calculate is in the negative. This is a very worrying sign as it indicates that the company is headed for a bankruptcy situation.

What industries have high D/E ratios?

The financial services and banking sector has companies with high D/E ratios. This is because the nature of the business means that their branch networks are their fixed assets, and they raise debt to perform their operations. Other industries, such as large manufacturers or airlines, also have high D/E ratios. They are capital-intensive operations, and they use debt financing to provide this.

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