What it means
Two companies with identical operations can have very different balance sheets depending on how they are financed. One might have been funded entirely by its shareholders; the other might have borrowed most of its capital.
The debt-to-equity ratio distinguishes them. It expresses the balance between the two sources of funding as a multiple, and the multiple tells a reader how leveraged the company is: how much borrowed money is working alongside each dollar of the owners' money, and therefore how much the company's fixed obligations and its financial risk have been increased in pursuit of higher returns.
Leverage cuts both ways, and the ratio measures the size of the lever. When a company earns more on its assets than it pays on its borrowings, the surplus accrues to shareholders, and the higher the ratio, the more of it there is per dollar of equity: return on equity rises with leverage.
When the company earns less on its assets than its borrowing costs, the shortfall also falls on shareholders, and the higher the ratio, the worse it is. A company with a debt-to-equity ratio of 0.5 that has a poor year sees its return on equity fall; a company with a ratio of 3.0 in the same poor year may see its equity wiped out.
The ratio is therefore read alongside the volatility of the company's earnings: leverage that is prudent for a water utility is reckless for a mining explorer. As with the other leverage ratios, the definition must be checked.
The broadest version uses all liabilities, including trade payables, accruals, provisions, deferred tax and lease liabilities, and is the version most often found in textbooks and in simple screening. The narrower version uses only interest-bearing debt (loans, bonds, overdrafts, finance leases) and is the version lenders and analysts usually mean when they speak of gearing.
A net version deducts cash from debt. The three can give very different figures for the same company, and the broad version is heavily affected by industry: a retailer with large trade payables looks highly leveraged on total liabilities and lightly leveraged on interest-bearing debt.
The equity figure also needs care. Book equity is share capital plus retained earnings plus reserves, less treasury shares, and it can be distorted by accounting: large intangible assets or goodwill inflate it, years of losses deplete it, and a company that has bought back many shares can have small or even negative book equity while being highly valuable.
Where equity is negative, the ratio is meaningless, and the analysis moves to cash flow measures. Market capitalisation can be used instead of book equity for a view of leverage at current values, which is the correct basis for cost-of-capital weights.
The ratio's uses are in lending, investment analysis and financial policy. Lenders set maximum ratios in covenants and price loans partly by reference to leverage.
Investors compare companies within an industry and watch the trend, since a rising ratio with flat profits means the company is borrowing to stand still. Boards set a target range that reflects their appetite for risk and their view of the cheapest sustainable mix of funding, and they use the ratio to decide between debt and equity when the company needs capital.
In all three uses, the ratio is a starting point that must be combined with measures of the company's ability to service its debt from earnings, such as interest cover and debt service coverage, because a balance sheet ratio alone does not show whether the payments can be met.
In practice
Real-world examples.
Example
A bank has a debt-to-equity ratio of 12 on total liabilities, because deposits are liabilities, which is normal for banking and is assessed through regulatory capital ratios rather than this measure.
Example
Two engineering companies have identical operating profits, but one has a ratio of 0.3 and the other 2.0; in a good year the second reports a higher return on equity, and in the downturn the second breaches its covenants while the first keeps paying dividends.
Example
A company that has bought back shares for years has book equity of only $5,000,000 against debt of $40,000,000, a ratio of 8.0, while its market capitalisation of $600,000,000 shows that the book figure no longer describes its financial position.
Think of it
“Debt-to-equity is like comparing how much of your house you borrowed versus how much you put down. Higher ratios mean more leverage.
Formula
Calculation
Debt-to-equity ratio (broad) = Total liabilities / Shareholders' equity
Debt-to-equity ratio (narrow, "gearing") = Interest-bearing debt / Shareholders' equity
Net debt-to-equity ratio = (Interest-bearing debt minus Cash) / Shareholders' equity
Return on equity = Net income / Shareholders' equity
Worked example. A company has total liabilities of $30,000,000, of which $18,000,000 is interest-bearing debt at 6%; cash of $3,000,000; and shareholders' equity of $20,000,000. Its tax rate is 25%.
- Broad ratio = $30,000,000 / $20,000,000 = 1.5
- Narrow ratio = $18,000,000 / $20,000,000 = 0.9
- Net ratio = ($18,000,000 minus $3,000,000) / $20,000,000 = 0.75
The effect of leverage on returns. Operating profit in a normal year is $6,000,000.
- Levered (as above): interest = $18,000,000 x 6% = $1,080,000; net income = ($6,000,000 minus $1,080,000) x 0.75 = $3,690,000; return on equity = $3,690,000 / $20,000,000 = 18.5%
- Unlevered alternative (same assets funded by $38,000,000 of equity and no interest-bearing debt): net income = $6,000,000 x 0.75 = $4,500,000; return on equity = $4,500,000 / $38,000,000 = 11.8%
- Leverage adds nearly seven points to the return on equity in a normal year
In a poor year with operating profit of $2,000,000:
- Levered: net income = ($2,000,000 minus $1,080,000) x 0.75 = $690,000; return on equity = 3.5%
- Unlevered: net income = $1,500,000; return on equity = 3.9%
- In the poor year the unlevered company does better, and if operating profit fell below $1,080,000 the levered company would make a loss while the unlevered one still made a profit
The interest of $1,080,000 is the fixed cost that leverage adds. Above the point at which operating profit covers it with a margin, leverage helps; below, it hurts; and the higher the ratio, the larger the fixed cost and the more the outcome swings.Case study
Seen in the real world.
Two regional retail chains competed in the same markets. Chain A was conservatively financed, with interest-bearing debt of $20,000,000 and equity of $40,000,000, a ratio of 0.5, and operating profit of $12,000,000.
Chain B had grown to more than twice the size by borrowing, with debt of $100,000,000 and equity of $40,000,000, a ratio of 2.5. For several years Chain B's strategy looked better: with operating profit of $20,000,000 and interest at 7% of $7,000,000, its return on equity was about 24% after tax, against Chain A's 20% (operating profit $12,000,000 less interest of $1,400,000, after tax), and its shares were more highly rated.
A consumer downturn cut both chains' operating profit by 60%: Chain A's to $4,800,000 and Chain B's to $8,000,000. Chain A's interest of $1,400,000 was still covered more than three times; it cut its dividend, kept investing in its stores and picked up market share. Chain B's interest of $7,000,000 was covered 1.1 times; its interest cover covenant of 2.5 times was breached, its lenders imposed a cash sweep and a higher margin, and its bond price fell sharply.
To restore its balance sheet, Chain B raised $30,000,000 of equity in a rights issue at a price 50% below the pre-crisis level, diluting existing shareholders by about 40%, and sold twelve stores to Chain A at distressed prices. Its ratio fell to 1.0, but its shareholders had lost most of what the leverage had earned them in the good years.
An analyst's review of the two chains over the full cycle found that Chain A's shareholders had earned a higher total return than Chain B's, with far less volatility, despite the lower return on equity in the good years. The analyst's conclusion was that the debt-to-equity ratio is not a measure of ambition but of exposure: Chain B's ratio of 2.5 had meant that a 60% fall in operating profit, which is a severe but not unprecedented event for a retailer, would consume the company's ability to service its debt. Chain A's board had priced that possibility; Chain B's had not.
Watch out
Common mistakes.
- Comparing ratios calculated on different definitions, such as total liabilities in one company and interest-bearing debt in another, which can differ by a factor of two or more.
- Reading a high ratio as bad and a low one as good without reference to the industry and the stability of earnings; the same ratio is prudent in one business and dangerous in another.
- Relying on book equity when it has been distorted by buybacks, goodwill or accumulated losses; check the market value and the cash flow measures.
Questions
People also ask.
What is a good debt-to-equity ratio?
For most trading companies, a narrow (interest-bearing debt) ratio below 1.0 is considered moderate and above 2.0 high; utilities and property companies run higher, technology and service businesses lower. The trend and the industry norm matter more than any absolute figure.
How does the ratio affect shareholders?
It magnifies their returns. When the company earns more on its assets than its borrowing cost, a higher ratio raises return on equity; when it earns less, a higher ratio lowers it faster and can turn profits into losses. Leverage increases both expected return and risk.
What is the difference between the debt-to-equity ratio and the debt ratio?
The debt ratio divides liabilities by total assets and lies between zero and one; the debt-to-equity ratio divides liabilities by equity and is unbounded. A debt ratio of 0.6 corresponds to a debt-to-equity ratio of 1.5.
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