What Is the Debt-To-Equity Ratio and How Is It Calculated?

The D/E ratio represents the proportion of financing that came from creditors (debt) versus shareholders (equity). Publicly traded companies that are in the midst of repurchasing stock may also want to control their debt-to-equity accounting marketing ratio. That’s because share buybacks are usually counted as risk, since they reduce the value of stockholder equity. As a result the equity side of the equation looks smaller and the debt side appears bigger.

How Businesses Use Debt-to-Equity Ratios

When it comes to choosing whether to finance operations via debt or equity, there are various tradeoffs businesses must make, and managers will choose between the two to achieve the optimal capital structure. Although debt financing is generally a cheaper way to finance a company’s operations, there comes a tipping point where equity financing becomes a cheaper and more attractive option. A higher D/E ratio means that the company has been aggressive in its growth and is using more debt financing than equity financing. A high D/E ratio suggests that the company is sourcing more of its business operations by borrowing money, which may subject the company to potential risks if debt levels are too high.

Why Debt Capital Matters

If earnings don’t outpace the debt’s cost, then shareholders may lose and stock prices may fall. Companies that don’t need a lot of debt to operate may have debt-to-equity ratios below 1.0. Other companies that might have higher ratios include those that face little competition and have strong market positions, and regulated companies, like utilities, that investors consider relatively low risk. If a company’s D/E ratio is too high, it may be considered a high-risk investment because the company will have to use more of its future earnings to pay off its debts. For example, asset-heavy industries such as utilities and transportation tend to have higher D/E ratios because their business models require more debt to finance their large capital expenditures. Interest payments on debt are tax-deductible, which means that the company can reduce its taxable income by deducting the interest expense from its operating income.

How to Calculate Debt to Equity Ratio (D/E)

Funds in your High-Yield Cash Account are automatically deposited into partner banks (“Partner Banks”), where that cash earns interest and is eligible for FDIC insurance. Your Annual Percentage Yield is variable and may change at the discretion of the Partner Banks or Public Investing. Apex Clearing and Public Investing receive administrative fees for operating this program, which reduce the amount of interest paid on swept cash. Rebate rates vary monthly from $0.06-$0.18 and depend on your current and prior month’s options trading volume.

Interpreting the Results

• That can happen when you have no debt on your balance sheet, and more than zero investment capital.
• The debt-to-equity ratio is important because it gives anyone analyzing your business’s financials a sense of whether your business is stable.
• In general, you’ll hope to keep your debt-to-equity ratio around 1 to 1.5, though if you’re in a highly capital-intensive industry, that ratio may creep up a bit higher without raising red flags.
• All Alpha output is provided “as is.” Public makes no representations or warranties with respect to the accuracy, completeness, quality, timeliness, or any other characteristic of such output.

Assessing whether a D/E ratio is too high or low means viewing it in context, such as comparing to competitors, looking at industry averages, and analyzing cash flow. The D/E ratio indicates how reliant a company is on debt to finance its operations. They do so because they consider this kind of debt to be riskier than short-term debt, which must be repaid in one year or less and is often less expensive than long-term debt. And, when analyzing a company’s debt, you would also want to consider how mature the debt is as well as cash flow relative to interest payment expenses.

These balance sheet categories may include items that would not normally be considered debt or equity in the traditional sense of a loan or an asset. Because the ratio can be distorted by retained earnings or losses, intangible assets, and pension plan adjustments, further research is usually needed to understand to what extent a company relies on debt. Additionally, if he tries to seek out small business financing in addition to his other debts, he may not be approved—or may have to pay very high fees in order to compensate for his high perceived risk.

The quick ratio is also a more conservative estimate of how liquid a company is and is considered to be a true indicator of short-term cash capabilities. The cash ratio compares the cash and other liquid assets of a company to its current liability. This method is stricter and more conservative since it only measures cash and cash equivalents and other liquid assets.

On the other hand, a comparatively low D/E ratio may indicate that the company is not taking full advantage of the growth that can be accessed via debt. Simply put, the higher the D/E ratio, the more a company relies on debt to sustain itself. Liabilities are items or money the company owes, such as mortgages, loans, etc. Relatively, Karen’s Kakes looks like a pretty stable business that’s not very highly leveraged.