Debt-to-equity ratio: A metric used to evaluate a company's financial leverage

• Debt-to-equity ratio measures a company's financial leverage by comparing total liabilities to its shareholder equity.
• A higher debt-to-equity ratio is often associated with risk, while lower ratios are considered safe.
• Debt-to-equity ratio varies by industry; some like banking and financial services have higher ratios.
• Read more stories from Personal Finance Insider.

When evaluating a company's financial health, you can use several liquidity ratios. One is the debt-to-equity (D/E) ratio, which compares total liabilities to total shareholder equity. Knowing the D/E ratio of a company can help you determine how much debt and equity it uses to finance its operations. Here's a quick overview of the debt-to-equity ratio, how it works, and how to calculate it.

What is debt-to-equity ratio?

The debt-to-equity ratio, also referred to as debt-equity ratio (D/E ratio), is a metric used to evaluate a company's financial leverage by comparing total debt to total shareholder's equity. In other words, it measures how much debt and equity a company uses to finance its operations. The D/E ratio is a crucial metric that investors can use to measure a company's financial health. 

How debt-to-equity ratio works

Debt and equity are two common variables that compose a company's capital structure or how it finances its operations. Investors typically look at a company's balance sheet to understand the capital structure of a business. 

The D/E ratio measures a company's total debt relative to its total equity. A high D/E ratio is typically associated with risk, meaning the company relies on debt to meet its financial growth. This tells investors that the underlying company depends on debt to finance its operations or make more extensive investments.

In some cases, investors may prefer a higher D/E ratio, especially when leverage is used to finance its growth. This is because the company can potentially generate more earnings than it would have without debt financing. Investors can benefit if leverage generates more income than the cost of the debt. But share values may fall when the debt's cost exceeds earnings.

A lower D/E ratio isn't necessarily a positive sign 一 it means a company is relying on equity financing, which is quite expensive than debt financing. However, some more conservative investors prefer companies with lower D/E ratios, especially if they pay dividends. 

"Interpreting debt-to-equity ratios is a bit of art mixed with a dash of science. The higher the debt-to-equity ratio is, the greater proportion of a company's finances comes from debt. It's true that the higher the ratio, the more the company relies on debt financing," says Robert R. Johnson, professor of finance at Heider College of Business, Creighton University and the founder of Economic Index Associates. 

"Some industries are more stable, though, and can comfortably handle more debt than others can. Industries that require large investment in equipment and those with stable cash flow 一 like electric utilities 一 tend to handle higher debt-to-equity ratios than those with less investment required, like software firms."

Note: The debt-to-equity ratio varies by the industry, thus difficult to compare across various industry groups. 

Debt-to-equity ratio formula and calculation

To calculate the debt-to-equity ratio, you divide a company's total liabilities by total shareholders' equity. Here's the formula for calculating the debt-to-equity ratio:

Alyssa Powell/Insider

The resulting figure represents a company's financial leverage 一 how much debt or equity it uses to finance its growth. Let's say company XYZ has a D/E ratio of 2.0, it means that the underlying company is financed by $2 of debt for every $1 of equity. 

The two components used to calculate the debt-to-equity ratio are readily available on a firm's balance sheet.

Total liabilities are combined obligations that a company owes other parties. These liabilities are typically broken down into three categories: short-term liabilities, long-term liabilities, and other liabilities.

Shareholders' equity, also referred to as stockholders' equity, is the owner's residual claims on a company's assets after settling obligations. It also represents a firm's total assets less liabilities.

Quick tip: When determining the D/E ratio of a company, it's crucial to focus on the long-term debts because the risks associated with long-term obligations vary from that of short-term debts. Using long-term debt will give you a more clear picture of the company's financial health.

Debt-to-equity ratio example

Let's look at a real-life example of one of the leading tech companies by market cap , Apple, to find out its D/E ratio. When you look at the balance sheet for the fiscal year ended 2021, Apple had total liabilities of $287 billion and total shareholders' equity of $63 billion.

Using the above formula, the D/E ratio of Apple is calculated by dividing $287 billion by $63 billion. The result is 4.6, meaning that Apple used $4.60 of debt for every dollar of equity. While Apple has a relatively high D/E ratio often associated with risk, it doesn't mean that it is experiencing financial distress. Typically, some industries, such as tech, manufacturing, and banking, tend to have higher D/E ratios than others.

Quick tip: When finding the D/E ratio of a company, it's vital to compare the ratios of other companies within their industries to see how they're performing. 

What is a good debt-to-equity ratio?

"A good debt-to-equity ratio really depends on the business in question, both in regards to its own financial strategy and the industry it operates within. Ratios over 2.0 are generally considered risky, whereas a ratio of 1.0 is considered safe," says Shaun Heng, vice president of growth and operations at CoinMarketCap.

However, that's not foolproof when determining a company's financial health. Some industries, like the banking and financial services sector, have relatively high D/E ratios and that doesn't mean the companies are in financial distress.

The D/E ratio is arguably one of the most vital metrics used to evaluate a company's financial leverage. It determines how much debt or equity a firm uses to finance its operations. A high D/E ratio is often associated with increased risk, while lower ratios are considered safe. 

However, D/E ratios vary by industry and, therefore, can be misleading if used alone to access a company's financial health. For this reason, using the D/E ratio along with other leverage ratios and financial information will give you a clearer picture of a firm's leverage.

Via PakApNews