Debt To Equity Ratio: Meaning, Types, Benefits & Limitations (2024)

TABLE OF CONTENT

  • What is Debt To Equity Ratio?
  • Debt to Equity Ratio Interpretation
  • Interpretation
  • How is Debt-To-Equity Ratio Calculated?
  • How Does a Debt-to-Equity Ratio Work?
  • Benefits of High Debt-to-Equity Ratio
  • Limitations of Debt-To-Equity Ratio
  • What are the Risks Involved in High-Debt-to Equity Ratio?

Debt To Equity Ratio: Meaning, Types, Benefits & Limitations

The most important thing to examine while gauging the health of a particular company is its financial standing. The risk gearing ratio or debt-to-equity ratio is a leverage used to carry out the company’s financial leverage.
Apart from that, it is also used to calculate the weight of total debt and financial liabilities against total shareholder’s equity.

What is Debt To Equity Ratio?

The debt-to-equity ratio is used to gauge the company’s capability to pay back its obligations. It basically shows the overall health of a particular company.
In case if the debt-to-equity ratio is higher, the company is receiving more financing by lending money subjecting to risk, and if potential debts are too high, there are chances of the company getting bankrupt during these times.
Several investors and lenders opt for a low debt-to-equity ratio because their interests are safeguarded If the business is declining.
However, the debt-to-equity ratio compares a company’s total liabilities to its shareholder equity and can be used to carry out how much leverage a company is using.
Generally, higher leverage signals to shareholders that a company or its stocks have a higher risk. However, it is tough to compare the debt-to-equity ratio across different industry groups where ideal debt amounts vary.
Investors modify the debt-to-equity ratio to focus entirely on long-term debt because the risk of long-term liabilities are different compared to short-term debts and payables.

Debt to Equity Ratio Interpretation

The debt-to-equity ratio helps companies analyze its financial strategy and helps them know if the company is using debt financing or equity financing for running their operations. There are two different types of debt-to-equity ratio

  • High debt-to-equity ratio
  • A high debt-to-equity indicates high risk. For example, if the company is lending money from the market to finance its operations for growth, it means a high debt-to-equity ratio.

  • Low debt-to-equity ratio
  • A low debt-to-equity ratio means the equity of the company’s shareholders is bigger, and it does not require any money to finance its business and operations for growth.
    In simple words, a company having more owned capital than borrowed capital generally has a low debt-to-equity ratio.

Interpretation

A high debt-to-equity ratio indicates that a company is borrowing more capital from the market to fund its operations, while a low debt-to-equity ratio means that the company is utilizing its assets and borrowing less money from the market.
Capital industries generally have a higher debt-to-equity ratio. In contrast, industries packed with services and technology have lower capital and growth needs on a comparative basis and therefore may have a lower DE.
Now by definition, you can come to the verdict and understand that a high debt-to-equity ratio is bad for a company and is viewed negatively by several analysts.

How is Debt-To-Equity Ratio Calculated?

The debt ratio formula is calculated by dividing a company’s total liabilities by shareholder’s equity. The formula is like this:
Debt-to-equity ratio = Total Liabilities/Shareholder’s Equity
The total liabilities include short-term debts, long-term debts, and fixed payments obligations.

How Does a Debt-to-Equity Ratio Work?

A high debt-to-equity ratio comes with high risk. If the ratio is high, it means that the company is lending capital from others to finance its growth. As a result, lenders and Investors often lean towards the company which has a lower debt-to-equity ratio.
However, the debt-to-equity ratio is compared to the data executed from other financial years. Therefore, if the debt-to-equity ratio shows a sudden increase, it means that the company has a growth strategy that is aggressively funding through debt.
The ratio should be compared with the average ratios to avoid confusion. Generally, companies with intensive capital tend to have a higher debt-to-equity ratio than service firms.

Benefits of High Debt-to-Equity Ratio

1. A high-debt to equity ratio signifies that a firm can fulfil debt obligations through its cash flow and leverage it to increase equity returns and strategic growth.
2. The cost of debt is lower than the cost of equity, and therefore increasing the debt-to-equity ratio up to a specific point can decrease a firm’s weighted average cost of capital (WACC).
3. Using more debts increases the company’s return on equity (ROE). However, the equity amount is smaller, and returns on equity is higher if the debt is used instead of equity.

Limitations of Debt-To-Equity Ratio

1. A debt-to-equity ratio of 1 is considered to be equal, i.e. total liabilities = shareholder’s equity. This ratio depends on the proportion of current and noncurrent assets because it is very industry-specific. It is said that companies with intensive capital will have a higher DE than service companies.
2. The maximum acceptable debt-to-equity ratio for more companies is between 1.5-2 or less. Large companies having a value higher than 2 of the debt-to-equity ratio is acceptable.
3. A debt-to-equity ratio indicates that a company may not be able to generate enough cash to satisfy its debt obligations. However, a company with a low debt-to-equity ratio means that a company is grabbing the advantage of the increased profit that financial leverage may bring.

What are the Risks Involved in High-Debt-to Equity Ratio?

There are two major risks involved in a high debt-to-equity ratio.
1. If the company has a high debt-to-equity ratio, any losses incurred will be compounded, and the company will find it difficult to pay back its debt.
2. If the debt-to-equity ratio is too high, there will be a sudden increase in the borrowing cost and the cost of equity. Also, the company’s weighted average cost of capital WACC will get too high, driving down its share price.

FAQS

  • What is the Debt To Equity Ratio?
  • The debt-to-equity ratio is used to gauge the company’s capability to pay back its obligations. It basically shows the overall health of a particular company.

  • What is the major benefit of a high debt-to-equity ratio?
  • The major benefit of high debt-to-equity ratio is:
    A high-debt to equity ratio signifies that a firm can fulfil debt obligations through its cash flow and leverage it to increase equity returns and strategic growth.

  • How is Debt-To-Equity Ratio Calculated?
  • The debt ratio formula is calculated by dividing a company’s total liabilities by shareholder’s equity. The formula is like this:
    Debt-to-equity ratio = Total Liabilities/Shareholder’s Equity

Debt To Equity Ratio: Meaning, Types, Benefits & Limitations (2024)

FAQs

Debt To Equity Ratio: Meaning, Types, Benefits & Limitations? ›

A high debt-to-equity ratio indicates that a company is borrowing more capital from the market to fund its operations, while a low debt-to-equity ratio means that the company is utilizing its assets and borrowing less money from the market. Capital industries generally have a higher debt-to-equity ratio.

What are the benefits of debt-to-equity ratio? ›

Why is debt to equity ratio important? The debt to equity ratio is a simple formula to show how capital has been raised to run a business. It's considered an important financial metric because it indicates the stability of a company and its ability to raise additional capital to grow.

What are the limitations of debt-to-equity ratio? ›

Drawbacks of a High D/E Ratio

In this case, any losses will be compounded down and the company may not be able to service its debt. If the debt to equity ratio gets too high, the cost of borrowing will skyrocket, as will the cost of equity, and the company's WACC will get extremely high, driving down its share price.

What is the debt equity ratio answer? ›

What Is the Debt-to-Equity (D/E) Ratio? The debt-to-equity (D/E) ratio is used to evaluate a company's financial leverage and is calculated by dividing a company's total liabilities by its shareholder equity.

How do you explain debt-to-equity ratio? ›

The debt-to-equity ratio (D/E ratio) shows how much debt a company has compared to its assets. It is found by dividing a company's total debt by total shareholder equity. A higher D/E ratio means the company may have a harder time covering its liabilities. A D/E can also be expressed as a percentage.

Is debt-to-equity ratio good or bad? ›

Financial experts generally consider a debt-to-equity ratio of one or lower to be superb. Because a low debt-to-equity ratio means the company has low liabilities compared to its equity , it's a common characteristic for many successful businesses. This usually makes it an important goal for smaller or new businesses.

What is the most important debt-to-equity ratio? ›

Generally, a good debt ratio is around 1 to 1.5. However, the ideal debt ratio will vary depending on the industry, as some industries use more debt financing than others.

Can a company have a negative debt-to-equity ratio? ›

It is possible for a company to have a negative debt-to-equity ratio. A negative D/E ratio means a company has more debt than assets. This could mean that the net worth of a company is less than zero.

How do you reduce debt-to-equity ratio? ›

Ways to reduce debt-to-equity ratio

One of the most effective ways to do this is to increase revenue. Then, as your company's equity increases, you can use the funds to pay off debts or purchase new assets, thereby keeping your debt-to-equity ratio stable. Effective inventory management is also important.

What is a good debt ratio? ›

If your debt ratio does not exceed 30%, the banks will find it excellent. Your ratio shows that if you manage your daily expenses well, you should be able to pay off your debts without worry or penalty. A debt ratio between 30% and 36% is also considered good.

What is a good equity ratio? ›

Still, as a general rule of thumb, most companies aim for an equity ratio of around 50%. Companies with ratios ranging around 50% to 80% tend to be considered “conservative”, while those with ratios between 20% and 40% are considered “leveraged”.

Is 0.5 a good debt-to-equity ratio? ›

Generally, a lower ratio is better, as it implies that the company is in less debt and is less risky for lenders and investors. A debt-to-equity ratio of 0.5 or below is considered good.

Is a positive debt-to-equity ratio good? ›

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.

Is it good if debt-to-equity ratio increases? ›

The debt-to-equity (D/E) ratio is a metric that provides insight into a company's use of debt. In general, a company with a high D/E ratio is considered a higher risk to lenders and investors because it suggests that the company is financing a significant amount of its potential growth through borrowing.

References

Top Articles
Latest Posts
Article information

Author: Rev. Porsche Oberbrunner

Last Updated:

Views: 6328

Rating: 4.2 / 5 (53 voted)

Reviews: 92% of readers found this page helpful

Author information

Name: Rev. Porsche Oberbrunner

Birthday: 1994-06-25

Address: Suite 153 582 Lubowitz Walks, Port Alfredoborough, IN 72879-2838

Phone: +128413562823324

Job: IT Strategist

Hobby: Video gaming, Basketball, Web surfing, Book restoration, Jogging, Shooting, Fishing

Introduction: My name is Rev. Porsche Oberbrunner, I am a zany, graceful, talented, witty, determined, shiny, enchanting person who loves writing and wants to share my knowledge and understanding with you.