However, since they have high cash flows, paying off debt happens quickly and does not pose a huge risk to the company. In a basic sense, Total Debt / Equity is a measure of all of a company’s future obligations on the balance sheet relative to equity. However, the ratio can be more discerning as to what is actually a borrowing, as opposed to other types of obligations that might exist on the balance sheet under the liabilities section. For example, often only the liabilities accounts that are actually labelled as « debt » on the balance sheet are used in the numerator, instead of the broader category of « total liabilities ». Because debt is inherently risky, lenders and investors tend to favor businesses with lower D/E ratios.
The Debt-to-Equity Ratio Formula
On the other hand, when a company sells equity, it gives up a portion of its ownership stake in the business. The investor will then participate in the company’s profits (or losses) and will expect to receive a return on their investment for as long as they hold the stock. This understanding is crucial for investors and analysts to ascertain a company’s financing strategy.
- In general, if a company’s D/E ratio is too high, that signals that the company is at risk of financial distress (i.e. at risk of being unable to meet required debt obligations).
- Whereas, equity financing would entail the issuance of new shares to raise capital which dilutes the ownership stake of existing shareholders.
- D/E ratios should always be considered on a relative basis compared to industry peers or to the same company at different points in time.
Total Assets
Different industries vary in D/E ratios because some industries may have intensive capital compared to others. Managers can use the D/E ratio to monitor a company’s capital structure and make sure it is in line with the optimal mix. The principal payment and interest expense are also fixed and known, supposing that the loan is paid back at a consistent rate. It enables accurate forecasting, which allows easier budgeting and financial planning.
What does it mean if the Debt Ratio is too high?
The debt ratio offers stakeholders a quick snapshot of a company’s financial stability. While this could indicate aggressive financial practices to seize growth opportunities, it might also mean a higher risk of financial distress, especially if cash flows become inconsistent. Regulatory and contractual obligations must be kept in mind when considering to increase debt financing.
Final notes on debt-to-equity ratios
Banks often have high D/E ratios because they borrow capital, which they loan to customers. At first glance, this may seem good — after all, the company does not need to worry about paying creditors. If a D/E ratio becomes negative, a company may have no choice but to file for bankruptcy. If the D/E ratio of a company is negative, it means the liabilities are greater than the assets. These can include industry averages, the S&P 500 average, or the D/E ratio of a competitor.
Both ratios, however, encompass all of a business’s assets, including tangible assets such as equipment and inventory and intangible assets such as copyrights and owned brands. Because the total debt to assets ratio includes more of a company’s liabilities, this number is almost always higher than a company’s long-term debt to assets ratio. In the consumer lending and mortgage business, sales tax definition two common debt ratios used to assess a borrower’s ability to repay a loan or mortgage are the gross debt service ratio and the total debt service ratio. It’s great to compare debt ratios across companies; however, capital intensity and debt needs vary widely across sectors. The financial health of a firm may not be accurately represented by comparing debt ratios across industries.
As is the story with most financial ratios, you can take the calculation and compare it over time, against competitors, or against benchmarks to truly extract the most valuable information from the ratio. As noted above, a company’s debt ratio is a measure of the extent of its financial leverage. Capital-intensive businesses, such as utilities and pipelines tend to have much higher debt ratios than others like the technology sector. While taking on debt can lead to higher returns in the short term, it also increases the company’s financial risk.
As an individual investor you may choose to take an active or passive approach to investing and building a nest egg. The approach investors choose may depend on their goals and personal preferences. Debt-to-equity ratio is just one piece of the puzzle when it comes to evaluating stocks.
