Capital-intensive industries like manufacturing, utilities, or telecommunications generally have higher debt-to-equity ratios due to large investments in infrastructure and equipment. Investors often look at the D/E ratio to assess the stability of a company. A low D/E ratio indicates that the company is less reliant on external debt, which can lead to greater financial security and a more predictable return on investment. By analyzing a company’s Debt to Equity Ratio, stakeholders can gauge its financial health, risk exposure, and ability to raise additional funds for expansion. However, a low D/E ratio is not necessarily a positive sign, as the company could be relying too much on equity financing, which is costlier than debt.
Airlines, as well as oil and gas refinement companies, are also capital-intensive and also usually have high D/E ratios. While a useful metric, there are a few limitations of the debt-to-equity ratio. 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). It’s also helpful to analyze the trends of the company’s cash flow from year to year. It’s clear that Restoration Hardware relies on debt to fund its operations to a much greater extent than Ethan Allen, though this is not necessarily a bad thing.
By using debt instead of equity, the equity account is smaller and therefore, return on equity is higher. It’s very important to consider the industry in which the company operates when using the D/E ratio. Different industries have different capital needs and growth rates, so a D/E ratio value that’s common in one industry might be a red flag in another.
What is a Good Debt to Equity Ratio?
These balance sheet categories may include items that wouldn’t normally be considered debt or equity in the traditional sense of a loan or an asset. Fundamental analysis is one of the most essential tools for investors and analysts alike, helping them assess the intrinsic value of a stock, company, or even an entire market. It focuses on the financial health and economic position of a company, often using key data such as earnings, expenses, ass…
What Industries Have High D/E Ratios?
To figure out a good d/e ratio, we need to check industry standards. For a mature company, a high D/E ratio can be a sign of trouble that the firm will not be able to service its debts and can eventually lead to a credit event such as default. For a growing company, a high D/E could be a healthy sign of expansion. In all cases, D/E ratios should be considered relative to a company’s industry and growth stage. A business that ignores debt financing entirely may be neglecting important growth opportunities. The benefit of debt capital is that it allows businesses to leverage a small amount of money into a much larger sum and repay it over time.
- A company’s stock could be more risky if its D/E ratio significantly exceeds those of others in its industry.
- The main use of the debt-to-equity ratio is to determine the financial leverage and risk of a company.
- On the other hand, a low d/e ratio could mean the company isn’t using debt well.
- In most cases, liabilities are classified as short-term, long-term, and other liabilities.
Company’s Growth Stage
There is no universally agreed upon “ideal” D/E ratio, though generally, investors want it to be 2 or lower. The investor has not accounted for the fact that the utility company receives a consistent and durable stream of income, so is likely able to afford its debt. This means that for every dollar in equity, the firm has 76 cents in debt. To get a sense of what this means, the figure needs to be placed in context by comparing it to competing companies. Of note, there is no “ideal” D/E ratio, though investors generally like it to be below about 2.
Step 1: Identify Total Debt
Conversely, a low D/E ratio suggests that a company has ample shareholders’ equity, reducing the need to rely on debt for its operational needs. This indicates that the company is primarily financed through its own resources, reflecting strong financial stability and a lower risk profile. The numerator in above formula consists of total current and long-term liabilities and the denominator consists of total stockholders’ equity, including preferred stock, if any. Both the elements of the formula can be obtained from company’s balance sheet. The platform helps businesses track, schedule, and manage debt repayments, ensuring timely payments and avoiding unnecessary interest expenses. By automating loan tracking, companies can reduce reliance on short-term debt and improve their financial leverage.
- The D/E ratio indicates how reliant a company is on debt to finance its operations.
- Let’s examine a hypothetical company’s balance sheet to illustrate this calculation.
- In our debt-to-equity ratio (D/E) modeling exercise, we’ll forecast a hypothetical company’s balance sheet for five years.
- What counts as a “good” debt-to-equity (D/E) ratio will depend on the nature of the business and its industry.
Changes in long-term debt and assets tend to affect the D/E ratio the most because the numbers tend to be larger than for short-term debt and short-term assets. Investors can use other ratios if they want to evaluate a company’s short-term leverage and its ability to meet debt obligations that must be paid over a year or less. Debt-financed growth can increase earnings, and shareholders should expect to benefit if the incremental profit increase exceeds the related rise in debt service costs. The share price may drop, however, if the additional cost of debt financing outweighs the additional income it generates. The cost of debt and a company’s ability to service it can vary with market conditions. Borrowing that seemed prudent at first can prove unprofitable later as a result.
A company’s stock could be more risky if its D/E ratio significantly exceeds those of others in its industry. Gearing ratios focus more heavily on the concept of leverage than other ratios used in accounting or investment analysis. The underlying principle generally assumes that some leverage is good, but too much places an organization at risk. Debt due sooner shouldn’t be a concern if we assume that the company won’t default over the next year.
Growth and Expansion Potential
When we look at a company’s financial health, we must consider the debt to equity ratio. The d/e ratio is found by dividing total liabilities by total tax definition shareholders’ equity. To grasp this ratio, we need to understand the parts of shareholders’ equity.
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). 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. Additionally, the growing cash flow indicates that the company will be able to service its debt level.
Investors may check it quarterly in line with financial reporting, while business owners might track it more regularly. Currency fluctuations can affect the ratio for companies operating in multiple countries. It’s advisable to consider currency-adjusted figures for a more accurate assessment.
Startups and early-stage companies often carry higher levels of debt as they seek to fund their growth strategies and establish themselves in the market. Conversely, companies that issue more equity (through stock issuance or retained earnings) will have a lower D/E ratio, reflecting a more conservative financial structure. A company’s ability to adjust to changing circumstances is influenced by its D/E ratio.
At the same time, it would maintain an elevated debt-to-equity ratio. However, a company with a low ratio sometimes encounters difficulty in covering interest expenses during periods of elevated interest rates. The ratio fails to quantify the extent to which a company comfortably meets its current debt obligations. Assessing interest coverage ratios provides a more accurate assessment of debt affordability.
Upon plugging those figures into our formula, the implied D/E ratio is 2.0x. Boost your confidence and master accounting skills effortlessly with CFI’s expert-led courses! Choose CFI for unparalleled industry expertise and hands-on learning that prepares you for real-world success.
In addition, the reluctance to raise debt can cause the company to miss out on growth opportunities to fund expansion plans, as well as not benefit from the “tax shield” from interest expense. Below are some examples of things that are and are not considered debt. This workflow shaved 80% off your initial research time, leaving you free to focus on management quality and growth catalysts. She holds a Bachelor of Science in Finance degree from Bridgewater State University and helps develop content strategies. InvestingPro offers detailed insights into companies’ D/E Ratio including sector benchmarks and competitor analysis. This result indicates that XYZ Corp has $3.00 of debt for every dollar of equity.