The debt-to-equity (D/E) ratio is a leverage ratio that shows how much a company's financing comes from debt or equity. A higher D/E ratio means that more of a company's financing is from debt versus issuing shares of equity. Banks may be able to operate healthily with a slightly elevated debt to equity ratio, particularly banks with a lot of fixed assets such as those with a large branch network. The industries with the highest debt-to-equity ratios tend to be those requiring large capital expenditures and infrastructure investment such as energy production, telecommunications, and utilities.
Calculating the D/E Ratio
The D/E ratio is calculated as total liabilities divided by total shareholders' equity. For example, if, as per thebalance sheet, the total debt of a business is worth $60 million and the total equity is worth $130 million, then the debt-to-equity is 0.46. In other words, for every dollar in equity, the firm has 46 cents in leverage. A ratio of 1 indicates that creditors and investors are balanced with respect to the company’s assets. The D/Eratio is considered a key financial metric because it indicates potential financial risk.
The D/E Ratio and Risk
A relatively high D/E ratio commonly indicates an aggressive growth strategy by a company because it has taken on debt. For investors, this means potentially increased profits with a correspondingly increased risk of loss. If the extra debt that the company takes on enables it to increase net profits by an amount greater than the interest cost of the additional debt, then the company should deliver a higher return on equity (ROE) to investors. However, a company with a high debt-to-equity ratio and a high return on equity is still seen as a more risky and less desirable investment than a company achieving the same return on equity with less debt.
However, if the interest cost of the extra debt does not lead to a significant increase in revenues, the additional debt burden would reduce the company's profitability. In a worst-case scenario, it could overwhelm the company financially and result in insolvency and eventual bankruptcy.
What Level of Debt-to-Equity Is Considered Desirable?
A high debt-to-equity ratio is not always detrimental to a company's profits. If the company can demonstrate that it has sufficient cash flow to service its debt obligations and the leverage is increasing equity returns, that can be a sign of financial strength. However, not all high debt-to-equity and high return on equity companies are so successful. Taking on more debt and increasing the D/E ratio boosts the company’s ROE.Using debt instead of equity means that the equity account is smaller and the return on equity is higher. The inflating of the return on equity metric by high debt, can hide problems within a company. A high ROE alone doesn't make a company a good investment. Other metrics must be examined to determine the health of the company.
Bank of America's D/E ratio for the first quarter of 2024 was1.01. This is considered a healthy debt-to-equity ratio. In the first quarter of 2010, coming out of the financial crisis, the ratio reached 2.23.
Typically, the cost of debt is lower than thecost of equity. Therefore, another advantage in increasing the D/E ratio is that a firm’s weighted average cost of capital (WACC), or the average rate that a company is expected to pay its security holders to finance its assets, goes down.
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.
In the banking industry a relatively high D/E ratio is acceptable in some situations. Banks with a lot of fixed assets such as those with a large branch network tend to carry slightly elevated amounts of debt in a healthy way.
