The debt to equity (D/E) ratio is a metric used in evaluating a company’s financial leverage. The ratio mirrors the ability of shareholder equity to cover all outstanding debts if there’s a decline in business.
To calculate the D/E ratio, divide a company’s total liabilities by its shareholder equity:
Debt to equity ratio = total liabilities ÷ total equity
A company’s financial statements hold the information needed for the D/E ratio on their balance sheet. The balance sheet requires total shareholder equity to equal assets minus liabilities. Check the rearranged equation below:
Assets = liabilities + shareholder equity
Earnings, losses, pension plan adjustments, and other assets can distort the D/E ratio. So, further research is needed to arrive at a company’s accurate leverage.
Analysts and investors usually modify the D/E ratio as some of the accounts in the balance sheet categories can be uncertain. The modification can make the D/E ratio more useful and easier to compare between different stocks.
Profit performance, short-term leverage ratios, and growth expectations can also be included in the analysis to improve the D/E ratio.
A high debt to equity ratio can be associated with high risk. This could mean a company has been aggressively financing its growth with debt.
The cost of debt varies with market conditions, in which futile borrowing may not be noticed at first. Hence, changes in long-term debt and assets tend to have a bigger impact on the D/E ratio than short-term debt and assets. A company could possibly earn more without even using debt for financing.
Other ratios will be used if anyone wants to evaluate a company’s short-term leverage and its ability to meet debt obligations, which must be paid over a year or less.
It’s necessary to consider the company’s industry when using the debt to equity ratio, as they have different capital needs and growth rates. A somewhat high D/E ratio may be common in one industry, while a low D/E may be common in another.
Example: Utility stocks, like consumer staples, usually have a very high D/E ratio in the market. A utility is able to maintain a steady income even though it grows slowly — allowing companies to borrow very cheaply. This represents an efficient use of capital.
Analysts cannot always agree on which is considered debt. Including some preferred stock in total debt will increase the D/E ratio and make a company riskier. Including some preferred stock in the equity portion of the D/E ratio will increase the denominator and lower the ratio.
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