A debt-to-equity ratio is one of the metrics you can use to evaluate a company’s health—specifically, whether or not the company is standing on stable financial ground.
What is a good debt-to-equity ratio? And how can you use the debt-to-equity ratio to guide your investment choices?
The debt-to-equity ratio (also known as the “D/E ratio”) is the measurement between a company’s total debt and total equity.
In other words, the debt-to-equity ratio tells you how much debt a company uses to finance its operations.
For instance, if a company has a debt-to-equity ratio of 1.5, then it has $1.5 of debt for every $1 of equity.
If you’re new to investing, then it might help to get familiarized with the following terms:
You can find a company’s debt-to-equity ratio on the company balance sheet.
Both the debt to equity ratio and gearing ratio are used to evaluate the financial health of a company. The debt to equity ratio is a measurement of the amount of debt a company holds compared to the amount of equity it holds. The gearing ratio is more focused on leverage. This means taking more financial risks into consideration including fixed interest and dividend-bearing funds.
Debt repayment can be a major financial strain on a business and significantly reduce its profit margin. You probably have your own experience with debt if you’ve ever taken out a mortgage, financed a vehicle, or received student loans. You’re probably well-aware of how those debts impact your checking account.
Debt is inherently risky. And, for businesses, it presents a mortal danger during an economic downturn. Recessions can damage a company’s cash flow, making it harder for the company to repay its outstanding debt and putting the business at greater risk of bankruptcy.
Many investors prefer to buy into companies that have a low debt-to-equity ratio. A company with fewer debts is less risky.
Let’s flip the tables and view the debt-to-equity ratio from a company’s perspective. If you’re a business owner, a high debt-to-equity ratio could impact your ability to get financing from creditors. For example, if you own a real estate company, a high debt-to-equity ratio could discourage lenders from giving you a mortgage loan. So the debt-to-equity ratio is an important number, whether you’re an investor or a business owner.
However, high debt is not necessarily an indicator that a company is struggling. Some investors prefer a higher debt-to-equity ratio. Some companies use debt to stimulate growth, in which case investors reap high returns if the growth plan is successful. We’ll discuss this in more detail.
You can calculate the debt-to-equity ratio by dividing a company’s total liabilities by its shareholder equity. Here’s the debt-to-equity ratio formula:
Let’s try it out. If a company has $120,000 in shareholder equity and $30,000 in liabilities, then:
You can also use this formula to calculate the debt-to-equity ratio of your personal finances.
Generally, a good debt-to-equity ratio is anything lower than 1.0. A ratio of 2.0 or higher is usually considered risky. If a debt-to-equity ratio is negative, it means that the company has more liabilities than assets—this company would be considered extremely risky. A negative ratio is generally an indicator of bankruptcy.
Keep in mind that these guidelines are relative to a company’s industry.
In some industries, businesses may tend to have higher debt-to-equity ratios, while the average debt-to-equity ratio is lower in other sectors.
For example, the finance industry (banks, money lenders, etc.) typically has higher debt-to-equity ratios because these companies leverage a lot of debt (usually when granting loans) to make a profit.
On the other hand, the service industry has lower debt-to-equity ratios because they have fewer assets to leverage.
As mentioned earlier, a high debt-to-equity ratio isn’t necessarily a bad thing. Some investors may prefer to invest in companies that are leveraging more debt. Furthermore, high debt is commonplace in certain industries.
You shouldn’t make an investment decision based solely on the debt-to-equity ratio. But you can use the debt-to-equity ratio to evaluate the financial prospects of a company.
When you’re doing stock research on a company, ask yourself the following questions:
Once you’ve found the debt-to-equity ratio for a prospective investment, compare it with other companies in the same industry. See whether or not the company’s D/E ratio is close to the industry average.
Even if the company’s D/E ratio is far above the industry average, we still have an incomplete picture of its overall financial health. You’ll want to check the other financial data included in the company’s financial statements.
Determine whether or not the company is turning a profit through its central business. Even if a company has a large amount of outstanding debt, strong profits could enable the company to pay its bills every month.
Debt isn’t always a bad thing—and, in some cases, it’s the only feasible way for a business to grow. If you’re thinking about investing in a company that has a higher debt-to-equity ratio, make sure that the company is using the debt to create lasting growth. You’re making sure that the company has a solid growth plan.
But how do you know whether or not a growth plan will be successful?
You can’t be 100% certain. You’ll have to use your insight and knowledge of the industry (this is why most investors advise you to invest in companies/industries you know very well).
Consider the following:
It doesn’t matter whether the company is leveraging debt by taking a loan, issuing bonds, or issuing new shares. If the company doesn’t have a plan for how it will leverage the debt—or if the debt is being used for unhelpful purposes, consider it a red flag.
Before you invest in any company, always imagine a worst-case scenario in which there’s a major economic downturn that significantly hinders a company’s profits.
Ask yourself: if the company’s revenue decreased by 30%-50%, would it prevent the company from paying its debt?
Remember that the Great Recession brought misfortune to many businesses—especially financial institutions, which tend to have higher debt-to-equity ratios. Don’t ever evaluate the health of a company by its peak performance. Always assume that the economy could swing downward.
Last but not least, consider your own risk tolerance. Are you comfortable investing in a company that has a higher debt-to-equity ratio? Or would you prefer investing in a safer company that has less debt?
Many companies leverage a large amount of debt to create strong, long-term growth—and investors who buy in early could potentially reap high, above-the-market returns.
The company could also fail to pay off the debt and go into bankruptcy—providing shareholders with a significant loss.
There’s nothing wrong with taking the safe route, especially if you’re a long-term investor who’s trying to save for retirement or create a passive income. If you plan to invest in a company with more debt, be sure that you have a diversified investment portfolio and restrict a smaller percentage of your portfolio to these high-risk stocks.
The debt-to-equity ratio is greatly skewed by long-term debt. Long-term debt tends to be more expensive and involves a larger sum of money. Although larger debts tend to be riskier, they’re also capable of generating the most growth.
Long-term debt is mostly used to:
If you’re a short-term investor (i.e., you plan on holding company stock for only a year or two), you might want to avoid using any metric that accounts for long-term debt. Here are a couple of alternative ratios you can use:
Perhaps you are interested in clean energy and automobiles, and you are inspired to consider investing in Tesla.
Let’s walk through the process of how you’d use the company’s debt-to-equity ratio to make an investment decision.
The company holds $16.89 billion in shareholder equity and $10.61 million in liabilities, so the debt-to-equity ratio is 0.63.
First, let’s compare that to other debt-to-equity ratios in the automaker industry (figures from September 2020):
Tesla has a great debt-to-equity ratio, and it’s lower than some of the other automakers. But the debt-to-equity ratio doesn’t tell the whole story. Let’s consider the following:
From all the information we’ve gathered, you decide that Tesla is a reliable and relatively safe investment. The decision wasn’t based solely on the debt-to-equity ratio, but the ratio helped us put together the company’s bigger financial picture.
The debt-to-equity ratio measures how much debt a company is using to finance its operations. So, what is a good debt-to-equity ratio? A higher debt-to-equity ratio indicates that a company has higher debt, while a lower debt-to-equity ratio signals fewer debts. Generally, a good debt-to-equity ratio is less than 1.0, while a risky debt-to-equity ratio is greater than 2.0. But this is relative—there are some industries in which companies regularly leverage more debt. The debt-to-equity ratio by itself won’t give you enough information to make an educated investment decision. Still, it can help you determine a company’s financial health and future risk.