What is (D/E) Debt-to-Equity Ratio Definition?
Debt-to-Equity Ratio (D/E) Definition
A company’s debt-to-equity ratio, or its D/E, describes to what extent a company is financed by debt relative to equity.
D/E is calculated by taking the sum of a business’s liabilities and dividing that number by the sum of its equity (see the equation below).
The resulting ratio, which can be expressed as an integer or multiplied by 100 to get a percentage, helps give investors an impression of how much financial leverage the company in question has.
Debt comes from issuing bonds or taking out loans.
These balances are recorded as liabilities on a company’s balance sheet.
Debts are considered liabilities because there is an expectation that after the borrowing period has ended, a company will be able to pay the debt back in full.
It must also keep up regular interest payments, meaning that the borrowing company will owe more in total than it took out.
This makes a company more risky for investors, who don’t want to be responsible for paying back excessive debt if it can’t be met by profits.
Unlike debt, there is no expectation of direct repayment on an investment. However, investors do expect that the money they put into a business will be used to help it grow and increase their return on investment.
For accounting purposes, when calculating D/E, usually only long-term debts and assets are considered.
This is because these balances tend to be much larger and longer lived.
If an investor wants to determine a business’s short-term leverage, they use different ratios.
The current ratio, for example, gauges a business’s short-term solvency by dividing its short-term assets by its short-term liabilities using the following formula:
Advantages of Using (D/E)
Calculating debt-to-equity as a ratio rather than as absolutes has the advantage of normalizing for company size. For example, two hypothetical car companies could both have D/E ratios of 0.5, or 50%.
However, Company A could have $50,000 in debt and $100,000 in retained earnings, and Company B could have $100,000 in debt and $200,000 in RE.
An investor could undervalue Company B for having $50,000 more in debt on its books, or overvalue it for having $100,000 more in retained earnings.
However, because the two companies have the same D/E ratio, investors can see that both companies are equally as healthy, albeit on different scales.
Depending on the industry in which a particular company operates, what is considered an acceptable debt-to-equity ratio can change.
For many companies, financing operations through debt is a common practice.
Companies that earn a relatively stable and consistent income and can pay off debts quickly will have a good credit quality, allowing them to borrow very cheaply.
Companies in the utilities sector, such as GE or Exxon, borrow heavily to pay for the expensive assets that are required for them to operate.
However, they earn a very high income and can pay these debts easily.
For these companies, a high D/E ratio doesn’t necessarily correlate with a high risk for investors.
Likewise, a very low debt-to-equity ratio does not always mean that a particular company is making efficient use of its funds.
If a company isn’t financed by debt at all, it could indicate that the company isn’t able to generate enough profit to pay back money it borrows.
It could also be a sign of poor management that is underinvesting in assets.