debt to equity ratio

Reviewed by Vishnava | Updated on Feb 01, 2024

Definition of debt to equity ratio

The debt-to-equity (D/E) ratio, which is determined by dividing a company's total liabilities by its shareholder equity, is used to assess financial leverage.
It expresses the willingness of shareholder equity to cover all unpaid debts in the event of a market downturn.

Since the D/E ratio compares a company's debt to the value of its net assets, it is commonly used to determine the extent to which a company is incurring debt to leverage its assets. A high D/E ratio is often correlated with risk; it indicates that a business has been successful in funding its growth with debt.
If a business uses a lot of debt to fund growth, it might be able to produce more earnings than it would have without the debt. Shareholders should continue to gain if leverage raises profits by more than the cost of debt (interest). However, if the cost of debt financing exceeds the increased revenue, share prices could fall. Debt costs can vary depending on market conditions. As a result, unprofitable borrowing might not be obvious at first.
Long-term debt and assets have the biggest effect on the D/E ratio because they are larger accounts than short-term debt and short-term assets.

It is important to remember the sector in which the business operates when using the D/E ratio. Since different industries have different capital requirements and growth rates, a relatively high D/E ratio in one industry may be normal, whereas a relatively low D/E ratio in another.
As compared to sector averages, utility stocks often have a very high D/E ratio. A utility grows slowly but typically maintains a consistent income stream, allowing these businesses to borrow very cheaply. In slow-growth industries with steady profits, high leverage ratios reflect an effective use of resources. Market staples, or the consumer non-cyclical sector, often has a strong D/E ratio since these businesses can borrow cheaply and have relatively stable profits.
Analysts are not always clear with their definition of debt. Preferred stock, for example, is often called equity, but the preferred dividend, par value, and liquidation rights make this type of equity seem much more like debt.
Incorporating preferred stock into overall debt raises the D/E ratio and makes a business seem riskier. Including preferred stock in the equity part of the D/E ratio raises the denominator while decreasing the ratio. When preferred stocks are included in the D/E ratio, it can be a major problem for companies such as real estate investment trusts (REITs).