Using and Understanding the Debt-Equity Ratio

By Sterling Xie

What is the debt-to-equity ratio?

The debt-to-equity ratio is often used by investors and financial analysts to analyze a company’s capital advantages and general financial health. Its formula is the quotient of total liabilities by shareholder equity. This ratio is generally used when companies are in large amounts of debt to determine if they are able to pay off the debt using shareholder equity. Therefore, a lower debt-to-equity (D/E) ratio means a more stable business that often has more investor stability. In contrast, a higher D/E ratio could mean a more profitable investment but would also come with higher risks.

How to strategize with D/E?

When using the debt-to-equity ratio to make investment decisions, it is important to note that it is difficult to compare the D/E ratio between different industries and sectors. The ideal amount of debt-to-equity ratio in different sectors is often also different as a result of different supply and demand situations and circumstances. For example, the utility industry often has an incredibly high D/E ratio because it is a necessity service and has a consistent income stream, meaning it is able to take on more debt without risk of default or bankruptcy.

You should use the D/E ratio to understand the market if you are a long-term investor because the D/E ratio deals with more long-term concerns in connection with long-term debt. Day traders that are more concerned with short-term stability and profitability often use the cash ratio or current ratio which deals with the current financial standings of a company including debt.

What classifies a good ratio?

A D/E ratio is good when it is 1.00 or under, representative of $1 of debt or under for every $1 of equity. This means if they are able to pay off all their debt even if they lost their income stream. However, a D/E ratio is a lot more risky when it is 2.00 or above. These companies would be volatile in the face of income cutoff.

What does D/E mean for you?

D/E ratios are important in determining the viability of investments and are important in creating more stable portfolios geared towards long-term investment. However, it is important to consider a diverse array of financial indicators outside of simply the D/E ratio as there are specific limitations to the D/E ratio.