The Debt to Equity (D/E) ratio is a straightforward metric that calculates the proportion of the debt of a company relative to its equity. In simple words, it is the ratio of the total liabilities of a company and its shareholders’ equity. It is one of the most favourite metrics for investors when deciding which company they want to invest in.
The reason behind the popularity of the D/E ratio is its simplicity. First of all, calculating the ratio is straightforward since its requisites are available in the company’s financial statements, particularly the Balance Sheet. Similarly, it is easy to understand and explain, which is why investors prefer it compared to more complex ratios.
How to calculate Debt to Equity ratio?
The formula to calculate the Debt to Equity Ratio of a company is as below.
D/E Ratio = Total Liabilities / Shareholders’ Equity
By calculating the D/E ratio of a company, investors can evaluate its financial leverage. It represents the ability of the company to cover its liabilities by using its shareholders’ equity. Furthermore, the ratio can help investors gain valuable insights into the company’s capital structure. It helps them determine whether the company depends more on debts or equity.
Usually, the lower the D/E ratio of a company is, the more preferable investing in it is for investors. However, an unconditionally low D/E ratio can also be problematic for various reasons. Nonetheless, there is no threshold as to how much the ratio should be for it to be considered acceptable. However, investors can use the D/E ratio as a comparative tool for a better understanding of how much it should be.
Example
A company, Red Co., has total liabilities of $30,000 and shareholders’ equity of $60,000. It’s D/E ratio, therefore, is 0.5. It means that for every $1 in shareholders’ equity, Red Co. has $0.5 in leverage. However, based on this ratio, investors cannot make a decision as it does not signify anything. Therefore, they must compare it with Red Co.’s competitors or its industrial average to get a better idea.
What does a high D/E ratio signify?
A high D/E ratio indicates a company is at a high leverage position. It signifies the company relies heavily on debt finance as compared to equity finance. However, it may not be a bad thing in some cases. That is because if the company can efficiently utilize its debt, it can decrease its cost of capital, thus, increasing returns. Debt usually comes at a lower cost for companies as compared to equity, which makes it more attractive.
What does a low D/E ratio signify?
A low D/E ratio indicates that the company has lower leverage and can, therefore, apply to receive more debt finance. Similarly, it means that the company won’t have to suffer as much in case it makes a loss as it doesn’t have an obligation to pay returns on equity. However, a low D/E ratio can also mean the company has a higher cost of capital.
Conclusion
The Debt to Equity Ratio is a useful metric when it comes to calculating the leverage position of a company. It’s simple to use and understand. Similarly, calculating the ratio is straightforward. While investors prefer a lower D/E ratio, it may not always be preferable.
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