How much leverage a company is using
In short:
The debt-to-equity (D/E) ratio is a measurement of a company’s financial leverage, that is, how much the company has borrowed vs how much the company’s owners have in equity. The D/E ratio is calculated by dividing a company’s total liabilities by its shareholder’s equity.
The value of the D/E ratio is that it allows investors and company managers to see how much their operations are being financed by lenders vs being financed by equity investors, i.e. a look at a company’s capital structure.
Key Points
- The debt-to-equity (D/E) ratio compares a company’s total debt to its total shareholder’s equity which gives an indication of the company’s leverage
- Different industries will have different D/E ratios. Sometimes higher ratios are typical and sometimes lower are typical. Too high a D/E ratio above the industry average indicates a much higher risk of default.
- Leverage (debt) allows a company to invest more in its operations at a lower cost, however, adds some degree of default risk to a company.
- D/E ratio is also called “debt-equity ratio”, “risk ratio”, or “gearing”
In-depth:
Understanding the Debt-to-Equity (D/E) Ratio
Understanding Leverage
Almost all companies use debt in some way to finance their operations similar to how most homes are sold via financing of a mortgage. Why? Because often it is cheaper to use debt to finance purchases of equipment, capital improvements, expansions, etc than it is to use equity. Debt can lower a company’s weighted average cost of capital (WACC). As a result, companies can often boost their net earnings by using debt.
However, there are limitations to everything. By using debt to finance operations companies are obligated to pay back the lenders plus interest, if they can’t, then the lenders typically have the right to take the assets, and companies file for bankruptcy protection. Think of it like you quit paying a home mortgage, the bank would eventually foreclose and take back the house.
Companies can get into this situation by overleveraging (borrowing too much). This happens when a company borrows more money than it can cover with the revenue it is generating and when it doesn’t have enough reserve equity capital to cover the cost of debt during hard times.
Use of D/E Ratio
For these reasons, investors and company managers might use the debt-to-equity (D/E) ratio to get a sense of how much leverage a company is using. Too much leverage and the company risk the situations we described above. Too little leverage and the company is not operating as efficiently as possible to maximize profits.
The D/E ratio tells investors how many dollars of debt a company has for every dollar of equity they have. So, if a company has a D/E ratio of 2.68, that means the company has $2.68 of debt for every $1 of equity they have.
How to Calculate the Debt-to-Equity (D/E) Ratio
On the surface, calculating the D/E ratio is quite simple as it is the total debt of a company divided by the total shareholder’s equity (Total assets minus total equity). These items are found on the balance sheet and the formula for calculating the D/E ratio we’ve included below:
Debt / Equity Ratio = Total Debt / Shareholder’s Equity
However, adjustments to the line items included or considered “debt” can be made by an analyst to refine or make the ratio more targeted. For example, maybe the analyst is primarily concerned with the long-term leverage of the company more so than the total leverage. In this case, they may choose to exclude some or all of the short-term debts a company has.
What is considered debt?
Debt is found on the liabilities side of the balance sheet yet not all liabilities fall into what is considered debt.
Debt liabilities
Long-term debt
Short-term debt
Lease obligations
Drawn lines of credit
Not Debt liabilities
Deferred Revenue
Accounts Payable
Accrued Expense
Example Calculation of the Debt-to-Equity Ratio
To get a better understanding of how the D/E ratio works and what might be included in the debt part of the calculation we can take a look at a simple example.
Let’s say we’re trying to analyze the leverage of an auto manufacturer. We take a look at its balance sheet and see the company has long-term debt of $40 billion, short-term debt of $2 billion, and accounts payable of $20 billion. Additionally, we know the company has shareholder’s equity of $30 billion. At this point we have enough information to calculate the D/E ratio as follows:
Debt / Equity = ( $40 billion + $2 billion) / $30 billion
Debt / Equity = 1.4
In this case, we do not include accounts payable as debt even though it shows up in the liabilities on the balance sheet. Even though this is a simple example, the logic used here applies to more complex situations. That is, only items used to finance the company’s operations or items that act as financing (leases) should be counted as debt.
How Does Leverage Increase Earnings
So how exactly does leverage (using debt) increase earnings? When a company uses debt to finance the purchase of its assets often it is extending the purchasing power of the equity (ownership capital) it has. This means the company is able to do more which could be using more assets to generate additional revenue.
Any additional net earnings from the additional assets funded by debt belong to the equity investors.
To help make this point clearer, consider the illustration below.
By using debt, the company is able to operate more assets with the same return, generate more revenue, and in this case increase the net earnings to equity owners.
Frequently Asked Questions
The debt-to-equity ratio is calculated by dividing total debt by total shareholder’s equity. It should be noted that total debt is not the same as total liabilities as not all liabilities are debt. Debt-to-equity formula: D / E = total debt / shareholder’s equity.
A debt-to-equity ratio of 1.5 means that for every $1 of equity a company has they have $1.5 of debt. So if a company has $1 million in equity, the company also has $1.5 million in debt and has assets of $2.5 million.
The debt-to-equity (D/E) ratio is a measurement of a company’s financial leverage, that is, how much the company has borrowed vs how much the company’s owners have in equity. In simple words, the debt-equity says how much a company is borrowing for every dollar of equity they have.