High levels of debt can increase a company’s risk of default and make it more vulnerable to economic downturns or changes in interest rates. Companies with high debt levels may face significant challenges if they cannot meet their debt obligations, especially during economic downturns or periods of low profitability. A higher ratio often indicates that the company is more vulnerable to financial distress if cash flows fluctuate or interest rates rise. Understanding the debt-to-equity (D/E) ratio is key for investors and analysts.
For instance, utility companies often exhibit high D/E ratios due to their capital-intensive nature and steady income streams. These companies frequently borrow extensively, given their stable returns, making high leverage ratios a common and efficient use of capital in this slow-growth sector. Similarly, companies in the consumer staples industry tend to show higher D/E ratios for comparable reasons. The D/E ratio can be skewed by factors like retained earnings or losses, intangible assets, and pension plan adjustments. Therefore, it’s often necessary to conduct additional analysis to accurately assess how much a company depends on debt.
She holds a Bachelor of Science in Finance degree from Bridgewater State University and helps develop content strategies. Your company owes a total of $350,000 in bank loan repayments, investor payments, etc. Profit and prosper with the best of Kiplinger’s advice on investing, taxes, retirement, personal finance and much more. You would be wise to do the same with your prospective investments. For example, utilities tend to be a highly indebted industry, whereas energy was the lowest in the second quarter of 2025. “The book value is beholden to many accounting principles that might not reflect the company’s actual value.”
“Ratios over 2.0 are generally considered risky, whereas a ratio of 1.0 is considered safe,” says Heng. A prospective mortgage borrower is more likely to be able to continue making payments during a period of extended unemployment if they have more assets than debt. This is also true for an individual who’s applying for a small business loan or a line of credit. In this example, your personal D/E ratio would be 1.53, which means you have $1.53 of debt for every $1 of equity. Your total assets would be $380,000, and your net worth would be $150,000 ($380,000 – $230,000).
Creditworthiness
- The debt to equity ratio is a useful tool for evaluating a company’s health.
- A negative debt-to-equity ratio can make securing future financing difficult due to your business’s heavy reliance on debt.
- Utilities often have higher ratios, while tech firms might have lower ratios for growth.
- Company XYZ, with a D/E ratio of 3.0, may be using more debt to finance its growth or operations.
On the other hand, industries with low d/e ratios, such as wholesalers and service sectors, are less impacted. When looking at a d/e ratio, it’s key to consider the company’s field and financial state. But, a ratio over 1 means more debt, which can raise financial risks. For example, a ratio of 2 shows the company owes twice as much as it owns.
For the remainder of the forecast, the short-term debt will grow by $2m each year, while the long-term debt will grow by $5m. 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. In this guide, we’ll explain everything you need to know about the D/E ratio to help you make better financial decisions.
- Bonds with higher yields or offered by issuers with lower credit ratings generally carry a higher degree of risk.
- You would be wise to do the same with your prospective investments.
- Investments in T-bills involve a variety of risks, including credit risk, interest rate risk, and liquidity risk.
- This issue is particularly significant in sectors that rely heavily on preferred stock financing, such as real estate investment trusts (REITs).
In contrast, industries like technology or services, which require less capital, tend to have lower D/E ratios. Generally, a ratio below 1 is considered safer, while a ratio above 2 might indicate higher financial risk. Total debt represents the aggregate of a company’s short-term debt, long-term debt, and other fixed payment obligations, such as capital leases, incurred during normal business operations. To accurately assess these liabilities, companies often create a debt schedule that categorizes liabilities into specific components. The debt-to-equity ratio may offer a snapshot of a company’s financial leverage.
How can you calculate the D/E Ratio using Microsoft Excel?
For instance, in times of low interest rates, companies may be more inclined to take on debt as borrowing becomes cheaper. On the other hand, service-oriented industries or technology firms often have lower ratios since they have fewer capital expenses and may rely more on equity. Lenders use the D/E ratio as a key indicator of a company’s creditworthiness.
Whether evaluating investment options or weighing business risks, the debt to equity ratio is an essential piece of the puzzle. The D/E ratio is a financial metric that measures the proportion of a company’s debt relative to its shareholder equity. It provides an understanding of how a company finances its assets. The ratio offers insights into the company’s debt level, indicating whether it uses more debt or equity to run its operations. In contrast, mature companies with stable cash flows may have lower debt levels and a more balanced capital structure, as they can rely more on retained earnings and equity financing. It measures the proportion of debt financing compared to shareholders’ equity, giving investors, lenders, and business owners a clear picture of financial leverage and risk exposure.
The debt to equity ratio is a significant metric that various stakeholders monitor for distinct reasons. Its importance stems from its ability to reveal a company’s financial structure and its reliance on external financing. To investors, the Debt to Equity Ratio shows how a company uses debt and equity financing.
A high ratio signals more debt use, suggesting higher risk but possibly higher returns. A low ratio indicates cautious use of debt with less risk but potentially lower returns. This ratio helps investors judge risk and understand the financing strategy. Ultimately, investors and analysts need to use a combination of industry context and company-specific factors to interpret a company’s D/E ratio and assess its financial health and risk profile. For example, a company with a high level of short-term debt may still be a good investment if it has strong cash flows and a solid track record of managing its obligations. Similarly, a company with a high level of long-term debt may be a risky investment if it is operating in a declining industry or has weak cash flows.
Banks, for example, often have high debt-to-equity ratios since borrowing large amounts of money is standard practice and doesn’t indicate mismanagement of funds. 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 what is debt to equity ratio 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. The necessary information to calculate the D/E ratio can be found on a company’s balance sheet. Subtracting the value of liabilities from total assets provides the figure for shareholder equity. A good debt-to-equity ratio is typically between 1 and 1.5, though it varies by industry (some industries use more debt financing than others).
