## What Is the Debt to Equity Ratio?

An essential formula in corporate finance, the debt-to-equity ratio (D/E) is used to measure leverage (or the amount of debt a company has) compared to its shareholder equity.

All companies have a debt-to-equity ratio, and while it may seem contrary, investors and analysts actually prefer to see a company with some debt. That’s because debt can be used to help companies finance activities that lead to long-term growth.

Consider debt as the amount of capital contributed by creditors, compared to the amount of capital contributed by shareholders (equity). Lenders want to see just how much a company owes others (debts) versus how much capital is available.

### Is a Low Debt to Equity Ratio Better?

Lenders and investors usually prefer low D/E ratios because their interests are better protected in the event of a business decline. Thus, firms with high debt to equity ratios may not be able to attract additional capital (equity). If a company owes too much, it may not be able to take on more debt or obtain additional capital from shareholders.

The video below offers more insight how the D/E ratio can be used to assess a company’s potential by investors:

## How to Calculate Debt to Equity Ratio

To calculate the debt-to-equity ratio, you’ll need to find the total liabilities and total shareholder equity (located on a company balance sheet). Liabilities are what the company owes others. Shareholder’s equity is the company’s book value – or the value of the assets minus its liabilities – from shareholders’ contributions of capital.

A D/E ratio greater than 1 indicates that a company has more debt than equity. A debt to income ratio less than 1 indicates that a company has more equity than debt.

## The Debt to Equity Ratio Formula

Calculate the D/E ratio with the following formula:

### Debt to Equity Ratio Example

Look at the balance sheet below:

## What Is an Ideal Debt to Equity Ratio?

Although a low debt to equity ratio may be more desirable, it’s not always practical: Some industries require more significant investments than others, especially when it comes to equipment and infrastructure.

Analysts, investors, and lenders use industry benchmarks to assess whether a company’s debt-to-equity ratio is high or low for the relevant industry average. D/E ratios of comparable companies (within the same industry) provide additional context to judge whether the ratio is too high, too low, or acceptable.

### What’s a Good Debt to Equity Ratio?

Investors typically look for a D/E ratio that hovers around the middle of the average industry range. Industry benchmarking sites provide the average ratio for a wide range of industries each year.

#### Industries with Lower D/E Ratios

Industries that tend to have low debt to equity ratios:

• Forestry

• Metal mining

• Agricultural services

• Personal services

#### Industries with Higher D/E Ratios

Industries with higher debt to equity ratios tend to invest more heavily in infrastructure and equipment to deliver their products and services, such as:

• Finance and banking

• Insurance

• Airlines

• Auto dealers

• Telecommunications

Railroads, for example, take on higher debt to pay for the equipment necessary to deliver their services. A new diesel locomotive costs between \$500,000 and \$2 million. If a railroad needs to replace several locomotives per year – or wishes to add to its fleet – it may need to take on debt, which can increase its debt-to-equity ratio.

## What’s a Negative Debt to Equity Ratio?

A negative debt-to-equity ratio occurs when a company has negative equity. If the book value of its shareholders’ capital is eroded by losses/negative profits – and the company is unable to earn profits – it may be unable to pay back its debt.

Before determining whether a negative D/E ratio is worrisome, analysts require further research to understand the situation and its implications.

## Limitations of the Debt to Equity Ratio

As with all financial metrics, the debt-to-equity ratio is only part of the whole picture. By itself, a low debt-to-equity ratio may not mean that a company is a good potential investment.

For example, if a company took on debt for expansion purposes, their debt-to-equity ratio may be high this year – but it may be a positive sign of growth. Reading through their entire annual report – and conducting further research – will provide a far clearer picture.

Lastly, capital-intensive industries (with high D/E ratios) may be a good investment after considering all factors. It is, however, only one of many financial ratios that investors and analysts consider while reviewing potential investments.

## Why Is the Debt to Equity Ratio Important?

Generally, a high debt to equity ratio indicates that a company may not be able to generate enough cash to satisfy its debt obligations. However, low debt to equity ratios may also indicate that a company isn't taking advantage of the increased profits that financial leverage may bring.

It’s important to remember that the comparison of debt-to-equity ratios is generally most meaningful among companies within the same industry, and the definition of a 'high' or 'low' ratio should be made within this context.