What Is a Good Debt-to-Equity Ratio and Why It Matters | Fi.Money (2024)

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What Is a Good Debt-to-Equity Ratio and Why It Matters | Fi.Money (13)

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What Is a Good Debt-to-Equity Ratio and Why It Matters | Fi.Money (14)

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Ulfath Joad

Ulfath Joad

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June 7, 2023

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The debt-to-equity ratio a.k.a. D/E ratio is one of the key financial metrics used by investors and analysts to evaluate the financial health of a company. If a company has a high D/E ratio, this means that it is high on debt as compared to equity. If you are wondering, “what is a good debt-to-equity ratio?” and “why does it matter?”, we have all the answers for you.

How is the D/E Ratio Calculated?

The formula used to calculate the D/E ratio is:

D/E ratio = Total debt of the company / total shareholder's equity

If company ABC has a total outstanding debt of ₹10 Lakhs while its total shareholder’s equity is ₹40 Lakhs, then the D/E ratio is 1/4 = 0.25. Is this debt-to-equity ratio good?

What if the situation was reversed and the debt was ₹40 Lakhs while the equity was only ₹10 Lakhs. Then the D/E ratio would be 4. So, what is the ideal debt-equity ratio?

What is a Good Debt-to-equity Ratio?

The first thing to note is that there is no fixed number that denotes how much debt-to-equity ratio is good for a company’s stock. There are several factors involved such as the industry or segment it operates in, the products or services it offers, global market trends, socio-economic and geo-political situation, etc. Having said that, most experts believe a D/E ratio between 1.5 to 2.5 shows the company is financially stable.

Taking the above examples, a D/E ratio of 0.25 is very good as it shows that the company is mostly funded by equity assets and has low obligations to repay. The second example though, where the D/E ratio is 4 shows the company is mostly financed by lenders, and may be a risky investment.

Why Do Investors Use the Debt-to-equity Ratio?

Investors and analysts use the D/E ratio to assess a company's risk profile and financial stability. Generally, a higher D/E ratio suggests higher financial risk. However, a higher D/E ratio can, at times, also indicate that a company is taking advantage of cheap debt financing to grow its operations, which can lead to higher profits. It is prudent to use the D/E ratio in the context of the industry and competition. Benchmarking is a valuable exercise that can help you gauge the company’s financial position in a more complete manner.

Drawbacks of the D/E Ratio

While the D/E ratio can serve as a measure of the financial leverage of a company and indicator of its solvency, it should not be used as the sole criterion for making your investment decision. This is because the debt-to-equity ratio varies across industries. For example, the transport sector is known to have a naturally higher debt-to-equity ratio than most other industries since there is a lot of initial loan that is borrowed to buy the fleet of vehicles.

Moreover, a D/E ratio does not convey the underlying circ*mstances of the company. For instance, a company may have a high D/E ratio indicating it has more debts currently. But, this does not necessarily mean the company is performing poorly. It is possible that the company has invested upfront in a major project or is heading towards a growth phase and needs to borrow the money to support it.

Conclusion

A smart investor is an informed investor. You can use the debt-to-equity ratio to assess a company’s financial performance, but it is important to understand the context, the other financial metrics of the company (like earnings, assets, liabilities, etc.), and use the industry-wide benchmark to compare with, and identify if the debt-to-equity ratio is good or not. Having done your research, you can go ahead and invest in Indian or even US stocks for more global exposure.

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Frequently Asked Questions

1. Is a debt-to-equity ratio below 1 good?

Yes, a D/E ratio below 1 shows that the company has more equity-backed financing and lesser debts in comparison. However, do not use the D/E ratio as a standalone metric to evaluate the company’s performance.

2. Is a debt ratio of 50% good?

Yes, a D/E ratio of 50% or 0.5 is very good. This means it is a low-debt business and the company’s equity is twice as high as its debts.

3. What is an acceptable debt-to-equity ratio?

The D/E ratio can vary as per the industry and various other factors that influence the company’s performance. However, it is generally agreed that a debt-to-equity ratio between 1.5 to 2.5 indicates a financially stable company with a low risk profile.

What Is a Good Debt-to-Equity Ratio and Why It Matters | Fi.Money (15)

Investment and securities are subject to market risks. Please read all the related documents carefully before investing. The contents of this article are for informational purposes only, and not to be taken as a recommendation to buy or sell securities, mutual funds, or any other financial products.

What Is a Good Debt-to-Equity Ratio and Why It Matters | Fi.Money (2024)

FAQs

What Is a Good Debt-to-Equity Ratio and Why It Matters | Fi.Money? ›

Overall, however, a D/E ratio of 1.5 or lower is considered desirable, and a ratio higher than 2 is considered less favorable. D/E ratios vary significantly between industries, so investors should compare the ratios of similar companies in the same industry.

What is a good debt-to-equity ratio and why does it matter? ›

The optimal D/E ratio varies by industry, but it should not be above a level of 2.0. A D/E ratio of 2 indicates the company derives two-thirds of its capital financing from debt and one-third from shareholder equity.

Is a debt-to-equity ratio of 1.4 good? ›

When it comes to debt-to-equity, you're looking for a low number. This is because total liabilities represents the numerator of the ratio. The more debt you have, the higher your ratio will be. A ratio of roughly 2 or 2.5 is considered good, but anything higher than that is considered unfavorable.

Is a debt-to-equity ratio of 40% good? ›

A debt ratio between 30% and 36% is also considered good. It's when you're approaching 40% that you have to be very, very vigilant. With a threshold like that, you're a greater risk to lenders. You may already be having trouble making your payments each month.

Is a debt-to-equity ratio of 50% good? ›

Yes, a D/E ratio of 50% or 0.5 is very good. This means it is a low-debt business and the company's equity is twice as high as its debts.

What is a really good debt-to-equity ratio? ›

What is a good debt-to-equity ratio? Although it varies from industry to industry, a debt-to-equity ratio of around 2 or 2.5 is generally considered good. This ratio tells us that for every dollar invested in the company, about 66 cents come from debt, while the other 33 cents come from the company's equity.

Why is the debt ratio important? ›

The debt ratio of a business is used in order to determine how much risk that company has acquired. A low level of risk is preferable, and is linked to a more independent business that does not need to rely heavily on borrowed funds, and is therefore more financially stable.

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 debt-to-equity ratio of 0.75 good? ›

Good debt-to-equity ratio for businesses

Many investors prefer a company's debt-to-equity ratio to stay below 2—that is, they believe it is important for a company's debts to be only double their equity at most. Some investors are more comfortable investing when a company's debt-to-equity ratio doesn't exceed 1 to 1.5.

What does a debt-to-equity ratio of 1.2 mean? ›

Debt to Equity Ratio Example

Its total liabilities are $300,000 and shareholders' equity is $250,000. With a debt to equity ratio of 1.2, investing is less risky for the lenders because the business is not highly leveraged — meaning it isn't primarily financed with debt.

Is a 60 40 debt to equity ratio good? ›

The 40-60 rule of debt and equity ratio refers to a target ratio that firms aim to achieve in their capital structures. This ratio suggests that firms should have 40% of their capital in the form of debt and 60% in the form of equity. The goal is to strike a balance between the benefits and costs of debt.

What does debt-equity ratio of 0.4 mean? ›

From a pure risk perspective, debt ratios of 0.4 or lower are considered better, while a debt ratio of 0.6 or higher makes it more difficult to borrow money. While a low debt ratio suggests greater creditworthiness, there is also risk associated with a company carrying too little debt.

What is a bad debt ratio? ›

The bad debt to sales ratio represents the fraction of uncollectible accounts receivables in a year compared to total sales. For example, if a company's revenue is $100,000 and it's unable to collect $3,000, the bad debt to sales ratio is (3,000/100,000=0.03).

What is Apple's debt-to-equity ratio? ›

Apple has a total shareholder equity of $74.1B and total debt of $108.0B, which brings its debt-to-equity ratio to 145.8%. Its total assets and total liabilities are $353.5B and $279.4B respectively. Apple's EBIT is $118.7B making its interest coverage ratio 648.4. It has cash and short-term investments of $73.1B.

Is debt-to-equity of 0 good? ›

While this may sound like an attractive financial position, it's not necessarily always good. On the positive side, a zero debt-to-equity ratio can mean that a company has a strong financial position, is not burdened with debt payments, and has greater flexibility in its financial management.

Can debt-to-equity ratio be over 100? ›

Key Takeaways

A debt ratio of greater than 1.0 or 100% means a company has more debt than assets while a debt ratio of less than 100% indicates that a company has more assets than debt.

Is having a high debt-to-equity ratio good? ›

The debt-to-equity (D/E) ratio reflects a company's debt status. A high D/E ratio is considered risky for lenders and investors because it suggests that the company is financing a significant amount of its potential growth through borrowing.

What is a 1.5 debt-to-equity ratio? ›

A debt-to-equity ratio of 1.5 would indicate that the company in question has $1.50 of debt for every $1 of equity. To illustrate, suppose the company had assets of $2 million and liabilities of $1.2 million. Since equity is equal to assets minus liabilities, the company's equity would be $800,000.

What if the debt-to-equity ratio is less than 1? ›

The debt to equity ratio shows a company's debt as a percentage of its shareholder's equity. If the debt to equity ratio is less than 1.0, then the firm is generally less risky than firms whose debt to equity ratio is greater than 1.0.

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