Debt-to-Equity Ratio Explained

The classical definition of a company’s debt-to-equity ratio is calculated by dividing the total liabilities appearing on the balance sheet by the company’s total shareholder’s equity, also found on their balance sheet. A company whose total liabilities are equal to their shareholder’s equity will have a debt-to-equity ratio of 1.0. A company whose liabilities are twice the level of their shareholder’s equity will have a ratio of 2.0.

Morningstar and others look at this ratio a bit differently. Their definition is “The debt/equity ratio is calculated by dividing a company’s long-term debt by total shareholders’ equity. It measures how much of a company is financed by its debtholders compared with its owners.”

Financial leverage

This ratio is then used to evaluate the level of financial leverage employed by the company. Financial leverage pertains to the use of borrowed funds to finance the acquisition of assets for the company. Companies have two basic means of financing their assets, debt, or equity.

The use of debt, whether borrowing in the bond market, bank debt in the form of loans, or other liabilities (such as accounts payable) provides leverage. At its best, leverage can help accelerate growth assuming the company continues to grow sales and profits. This assumes the cost of repaying the company’s debt is lower than the growth in the company’s profits.

Financial leverage can help increase the company’s return on shareholder’s equity if the company’s revenues and earnings keep growing. Think of financial leverage as having a sort of multiplier effect. If the company is growing, this growth was financed with “other people’s money” so to speak. Growth can be magnified. Beyond this, interest paid on this debt is generally tax deductible.

Leverage can also increase the company’s risk. Debt has to be repaid. If the company’s earnings are insufficient to do this, the company could be forced into bankruptcy. Short of this, the cost of servicing the company’s debt can consume a high level of the company’s cash flow to the point of inhibiting its ability to invest funds back into the company and to grow.

Leverage can be an issue for a company that is involved in a cyclical business such as selling consumer discretionary items like high-end automobiles or luxury vacations. During a downturn in the economy, consumers may forgo these items, especially if they have concerns about their jobs. Companies in these and other cyclical businesses who are carrying high levels of debt during these periods my feel the impact on their earnings and cashflow as their debt will continue to require interest payments regardless of how much or little the company is earning.

The debt-to-equity ratio is a key ratio for analysts and other investors reviewing a company’s balance sheet and overall financial structure, but it does have some limitations. As with any financial ratio, those analyzing the financial structure of a company need to dig deeper to get a full picture of the company’s financial strengths and weaknesses.

How to calculate the debt-to-equity ratio

A company’s debt-to-equity ratio is calculated by dividing it’s total debt by its shareholders’ equity. Let’s look at a couple of examples using date from their balance sheets as of the end of 2018. This data was taken from information provided on the Morningstar site.

Apple (ticker AAPL)

Debt $108.05

Shareholder’s equity $107.15

(amounts in billions of dollars)

Dividing $258.58 by $107.15 provides a debt-to-equity ratio of 1.01.

Duke Energy Corp. (ticker DUK)

Duke Energy is one of the largest utility holding companies in the U.S., owning both electric and gas utility providers in several states.

Debt $57.94

Shareholder’s equity $43.83

(amounts in billions of dollars)

Dividing $57.94 by $43.83 provides a debt-to-equity ratio of 1.32.

Johnson & Johnson (ticker JNJ)

Johnson &Johnson is one the world’s largest diversified healthcare company.

Debt $30.48

Shareholder’s equity $59.75

(amounts in billions of dollars)

Dividing $30.48 by $59.75 provides a debt-to-equity ratio of 0.51.

What is a good debt-to-equity ratio?

The answer to what constitutes a good debt-to-equity ratio will vary by company and the industry that they are in. For example, a utility company will regularly employ debt to finance its capital expenditures surrounding the infrastructure needed to provide power and related services to its customers.

As mentioned above, companies that are engaged in capital intensive businesses like utilities, some manufacturers, transportation companies including trucking companies and railroads and others may well have relatively high debt-to-equity ratios. These companies make capital investments in long-term assets like buildings, infrastructure, heavy equipment, etc.

Contrast this to other companies in service industries, for example, where the need for capital investments is generally much smaller. Investors would expect these firms to employ lower levels of debt in their financial structure.

Additionally, what is the company’s capacity to handle their current debt or additional debt? Are revenues increasing? Is the company’s product or service one that is in demand almost regardless of the prevailing business and economic conditions?

All of these factors go into answering the question, what is a good debt-to-equity ratio?

Beyond long-term debt

It’s also important to look beyond just a company’s debt-to-equity ratio and to look into the details of the company’s liabilities. While debt in the form of a loan or the issuance of bonds are part of the definition of liabilities, so are short-term liabilities such as accounts payable or salaries payable. These represent current liabilities, which by definition are those that come due within a year. These types of liabilities are often those incurred in the normal course of the company’s business.

Accounts payable might be for items like office supplies, fuel, materials used in the course of the company’s operations, and other similar types of expenses. This differs from longer-term debt in the form of a bank loan or a bond issuance to finance the purchase of capital equipment, the building of a facility or other types of long-term endeavors. Longer-term debt can also be a source of permanent capital for the company.

Wages payable are generally salaries that have been earned but not yet paid. Again, this is a liability that arises from the company’s normal business operations. A company that borrows to cover its salary obligations might be a bad sign about that company.

This is why the definition that uses just the company’s debt versus all liabilities as the numerator of the fraction makes sense.

Certainly, if a company’s debt-to-equity is significantly higher than that of other firms in its industry this could be a red flag for investors.

Uses and advantages of the debt-to-equity ratio

A company’s debt-to-equity ratio is useful, but its usefulness is limited.

The ratio tells us the amount of debt the company has compared to the level of equity on its balance sheet. Further it tells investors how the company is capitalized. A company’s debt-to-equity ratio will be a factor that will be considered when the company needs to raise additional capital. Lenders will look closely at a company’s debt-to-equity ratio in making their lending decision.

A company’s whose debt-to-equity ratio is high, by whatever standard the prospective lender uses in making lending decisions, will be considered as a higher risk borrower than others all things being equal. The high level of debt can pose a risk of default if the company’s financial and business prospects turn south.

A high debt-to-equity ratio can be a sign that company’s financial structure puts it at risk should the company’s business fortunes turn downward. Interest payments are a fixed expense that needs to be paid by the company regardless of its financial situation.

That said, the debt-to-equity ratio must be viewed in the context of a thorough and complete financial analysis of the company. Debt in and of itself is not a bad thing on a company’s balance sheet.A company using little or no debt as part of its financial structure isn’t necessarily a good thing either. This may be an indication of a company that is poorly managed from a financial standpoint.

Often the right financial structure is a mix of debt and equity. Debt provides a degree of financial leverage that can provide a “multiplier” effect on increased revenue and profit.

If using the more traditional debt-to-equity formula of total liabilities divided by shareholder’s equity, you must analyze all of the company’s liabilities to understand how these liabilities will flow through the balance sheet and income statement over time.

Understanding what a company’s debt-to-equity ratio tells you is a first step in the analysis of a company. Understanding this ratio in the context of the company’s overall financial and business picture can help investors and analysts gain insights into a company’s financial strengths and weaknesses.