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- Debt-to-equity ratio measures a company's financial leverage by comparing total liabilities to its shareholder equity.
- A higher debt-to-equity ratio is often associated with risk, while lower ratios are considered safe.
- Debt-to-equity ratio varies by industry; some like banking and financial services have higher ratios.
- Read more stories from Personal Finance Insider.
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When evaluating a company's financial health, you can use several liquidity ratios. One is the debt-to-equity (D/E) ratio, which compares total liabilities to total shareholder equity. Knowing the D/E ratio of a company can help you determine how much debt and equity it uses to finance its operations. Here's a quick overview of the debt-to-equity ratio, how it works, and how to calculate it.
What is debt-to-equity ratio?
The debt-to-equity ratio, also referred to as debt-equity ratio (D/E ratio), is a metric used to evaluate a company's financial leverage by comparing total debt to total shareholder's equity. In other words, it measures how much debt and equity a company uses to finance its operations. The D/E ratio is a crucial metric that investors can use to measure a company's financial health.
How debt-to-equity ratio works
Debt and equity are two common variables that compose a company's capital structure or how it finances its operations. Investors typically look at a company's balance sheet to understand the capital structure of a business.
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The D/E ratio measures a company's total debt relative to its total equity. A high D/E ratio is typically associated with risk, meaning the company relies on debt to meet its financial growth. This tells investors that the underlying company depends on debt to finance its operations or make more extensive investments.
In some cases, investors may prefer a higher D/E ratio, especially when leverage is used to finance its growth. This is because the company can potentially generate more earnings than it would have without debt financing. Investors can benefit if leverage generates more income than the cost of the debt. But share values may fall when the debt's cost exceeds earnings.
A lower D/E ratio isn't necessarily a positive sign 一 it means a company is relying on equity financing, which is quite expensive than debt financing. However, some more conservative investors prefer companies with lower D/E ratios, especially if they pay dividends.
"Interpreting debt-to-equity ratios is a bit of art mixed with a dash of science. The higher the debt-to-equity ratio is, the greater proportion of a company's finances comes from debt. It's true that the higher the ratio, the more the company relies on debt financing," says Robert R. Johnson, professor of finance at Heider College of Business, Creighton University and the founder of Economic Index Associates.
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"Some industries are more stable, though, and can comfortably handle more debt than others can. Industries that require large investment in equipment and those with stable cash flow 一 like electric utilities 一 tend to handle higher debt-to-equity ratios than those with less investment required, like software firms."
Debt-to-equity ratio formula and calculation
To calculate the debt-to-equity ratio, you divide a company's total liabilities by total shareholders' equity. Here's the formula for calculating the debt-to-equity ratio:
The resulting figure represents a company's financial leverage 一 how much debt or equity it uses to finance its growth. Let's say company XYZ has a D/E ratio of 2.0, it means that the underlying company is financed by $2 of debt for every $1 of equity.
The two components used to calculate the debt-to-equity ratio are readily available on a firm's balance sheet.
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Total liabilities are combined obligations that a company owes other parties. These liabilities are typically broken down into three categories: short-term liabilities, long-term liabilities, and other liabilities.
Shareholders' equity, also referred to as stockholders' equity, is the owner's residual claims on a company's assets after settling obligations. It also represents a firm's total assets less liabilities.
What is a good debt-to-equity ratio?
"A good debt-to-equity ratio really depends on the business in question, both in regards to its own financial strategy and the industry it operates within. Ratios over 2.0 are generally considered risky, whereas a ratio of 1.0 is considered safe," says Shaun Heng, vice president of growth and operations at CoinMarketCap.
However, that's not foolproof when determining a company's financial health. Some industries, like the banking and financial services sector, have relatively high D/E ratios and that doesn't mean the companies are in financial distress.
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The D/E ratio is arguably one of the most vital metrics used to evaluate a company's financial leverage. It determines how much debt or equity a firm uses to finance its operations. A high D/E ratio is often associated with increased risk, while lower ratios are considered safe.
However, D/E ratios vary by industry and, therefore, can be misleading if used alone to access a company's financial health. For this reason, using the D/E ratio along with other leverage ratios and financial information will give you a clearer picture of a firm's leverage.
Lydia Kibet is a freelance writer with a knack for personal finance, investing, and all things money. She's passionate about explaining complex topics in easy-to-understand language. Her work has appeared in Business Insider, Investopedia, The Motley Fool, and GoBankingRates. She currently writes about personal finance, insurance, banking, real estate, mortgages, credit cards, loans, and more. Connect with her atlydiakibet.comorLinkedIn.
I am an expert and enthusiast-based assistant. I have access to a wide range of information and can provide assistance on various topics. I can help answer questions, provide information, and engage in discussions. If you have any questions or need assistance, feel free to ask!
Now, let's discuss the concepts mentioned in the article you provided.
Debt-to-Equity Ratio:
The debt-to-equity ratio is a financial metric used to evaluate a company's financial leverage. It compares a company's total debt to its total shareholder equity. This ratio helps investors understand how much debt and equity a company uses to finance its operations .
A higher debt-to-equity ratio is often associated with higher risk, as it indicates that the company relies more on debt to meet its financial obligations. On the other hand, lower ratios are considered safer, as they suggest that the company relies more on equity financing.
It's important to note that the debt-to-equity ratio can vary by industry. For example, industries like banking and financial services tend to have higher debt-to-equity ratios compared to industries with lower investment requirements, such as software firms .
To calculate the debt-to-equity ratio, you divide a company's total liabilities by its total shareholders' equity. The resulting figure represents the company's financial leverage, indicating how much debt or equity it uses to finance its growth.
It's worth mentioning that while the debt-to-equity ratio is an important metric, it should not be used in isolation to assess a company's financial health. It's recommended to consider other leverage ratios and financial information to get a clearer picture of a firm's leverage .
I hope this information helps! Let me know if there's anything else I can assist you with.