Debt-To-Equity Ratio: Explanation, Formula, Example Calculations

The company can use the funds they borrow to buy equipment, inventory, or other assets — or to fund new projects or acquisitions. The money can also serve as working capital in cyclical businesses during the periods when cash flow is low. The debt-to-equity ratio (D/E) is one of many financial metrics that helps investors determine potential risks when looking to invest in certain stocks.

Calculation of Debt To Equity Ratio: Example 1

If a company’s debt to equity ratio is 1.5, this means that for every $1 of equity, the company has $1.50 of debt. In most cases, a low shopify to xero debt to equity ratio signifies a company with a significantly low risk of bankruptcy, which is a good sign to investors. Despite being a good measure of a company’s financial health, debt to equity ratio has some limitations that affect its effectiveness.

1. The company who takes advantage of this opportunity will, if all goes as projected, generate an additional $1 billion of operating profit while paying $600 million in interest payments.
2. At the same time, the company has $250,000 in shareholder equity, $60,000 in reserves and surplus, and $10,000 in fictitious assets.
3. If the company is aggressively expanding its operations and taking on more debt to finance its growth, the D/E ratio will be high.

Debt-to-Equity (D/E) Ratio

However, industries may have an increase in the D/E ratio due to the nature of their business. For example, capital-intensive companies such as utilities and manufacturers tend to have higher D/E ratios than other companies. On the other hand, the typically steady preferred dividend, par value, and liquidation rights make preferred shares look more like debt. As a highly regulated industry making large investments typically at a stable rate of return and generating a steady income stream, utilities borrow heavily and relatively cheaply.

The Debt-to-Equity Ratio Formula

A variation is to how to calculate accrued vacation add all fixed payment obligations to the numerator of the calculation, on the grounds that these payments are akin to debt. For example, the remaining rent payments due on a lease could be included in the numerator. The numerator does not include accounts payable, accrued expenses, dividends payable, or deferred revenues.

Lenders use the D/E figure to assess a loan applicant’s ability to continue making loan payments in the event of a temporary loss of income. If both companies have $1.5 million in shareholder equity, then they both have a D/E ratio of 1. On the surface, the risk from leverage is identical, but in reality, the second company is riskier.

Companies finance their operations and investments with a combination of debt and equity. For purposes of simplicity, the liabilities on our balance sheet are only short-term and long-term debt. While not a regular occurrence, it is possible for a company to have a negative D/E ratio, which means the company’s shareholders’ equity balance has turned negative. However, a low D/E ratio is not necessarily a positive sign, as the company could be relying too much on equity financing, which is costlier than debt. The D/E ratio represents the proportion of financing that came from creditors (debt) versus shareholders (equity).

Debt financing happens when a company raises money to finance growth and expansion through selling debt instruments to individuals or institutional investors to fund its working capital or capital expenditures. A good D/E ratio also varies across industries since some companies require more debt to finance their operations than others. 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.

For this to happen, however, the cost of debt should be significantly less than the increase in earnings brought about by leverage. However, an ideal D/E ratio varies depending on the nature of the business and its industry because there are some industries that are more capital-intensive than others. Different industries vary in D/E ratios because some industries may have intensive capital compared to others. If the D/E ratio gets too high, managers may issue more equity or buy back some of the outstanding debt to reduce the ratio.