Debt to Equity Ratio Explained (2023): Simple Examples ✅ (2024)

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Do you know how to find good companies to invest in?

As is often the case, we’ve handed you a trick question. There are dozens of ways to approach it – good products, strong share price or trading volume, publicity, economic moats…the list goes on.

However, all of those factors are contingent, and some are quite hard to quantify. But there is a way of looking at things that is completely rational, quantifiable, and universal across the board – and it has to do with the fundamentals of doing business.

Debt and equity are two universal factors for all publicly-traded companies – and understanding both factors, and the metric that arises from their interplay – the debt to equity ratio, allows investors an easy way to gauge the financial health and future prospects of a business.

Financial health and future prospects, of course, translate to whether or not a business presents a good investment opportunity. This topic falls under the umbrella of fundamental analysis – a skill that is absolutely essential for investors of all stripes, particularly long-term, buy-and-hold investors.

Understanding the debt to equity ratio (and fundamental analysis in general) allows investors to make more profitable choices, accrue greater returns, and have a way of checking the long-term prospects of their portfolios.

Although the world of finance and investing can seem arcane and confusing, this topic is actually a breeze. Fundamental analysis might sound like it is complicated, but we promise it isn’t – and there isn’t all that much math to be done either. Understanding this stuff isn’t all that hard – but it is well worth the time and effort, so let’s get down to it.

Debt and Equity – Explained 👨‍🏫

Before we move on to the more advanced stuff, let’s take a step back and go back to the basics. Without a rock-solid grasp of how both debt and equity work, understanding the ratios derived from these basic metrics won’t be possible.

What is Debt and How Does it Work? 📘

Debt needs no introduction – most, if not all people have had experiences with it. Boiled down to the simplest terms, debt is when something (money in 90% of cases) is owed by one party to another.

Debt makes doing business easier – if a company can’t afford a large purchase or needs a cash injection, taking out a loan ameliorates those issues. At the same time, the business or institution doing the lending also benefits – debts aren’t given out of the goodness of one’s heart, but because debts must be repaid, and usually come with interest.

Debt comes in a variety of shapes and sizes – including revolving debt, unsecured debt, secured debt, and mortgages. Corporate debt can also come in two additional forms – corporate bonds issued by a business to raise capital, and commercial paper which operates on the same principle, but with a shorter maturity date.

However, not everything is rosy when it comes to debt. Having too much debt makes a business less appealing to investors, increases the odds of bankruptcy or insolvency, and restricts a business in terms of taking on new debt.

In order to determine how much debt a business has, investors have to use fundamental analysis. This will require access to fundamental data such as balance sheets, revenue, earnings, etcetera.

To get a company’s total debt, investors should use the following formula:

Short term debts + long term debts + fixed payments = total debt.

To use an example, let’s say a company has $700 issued in commercial paper, $900 in corporate bonds, a $1,200 loan, and $600 in fixed payment.

Short-term debt is $700 and long-term debt is $900+$1,200 = $2,100. When we include the $600 in fixed payments, and combine all three figures ($700+$2,100+ $600), the company’s total debt is $3,400.

What is Equity and How Does it Work? 📗

The other side of the same coin, equity fulfills the same role as debt – it is used to finance growth, expansion, and hopefully further profits down the line, but unlike debt, it works a bit differently.

When a company takes out a loan, it borrows money that it has to return at some point. With equity, a company sells off a stake or ownership in the business (usually in the form of shares/stock). Institutional and retail investors buy shares, the business receives funds, and in return, investors can profit from price appreciation, vote on company matters, and receive dividends.

To determine equity, investors once again turn to a balance sheet and other fundamental data. When calculating equity, there are two things to consider – assets and liabilities. The formula for determining equity is as follows:

Equity = Assets – Liabilities

Equity is also commonly referred to as shareholders’ equity.

A business with $40,000 in assets and $25,000 in liabilities has $40,000 – $25,000 = $15,000 in equity. If that same business were to increase its liabilities to $50,000, then the equation looks like this: $40,000 – $50,000 = -$10,000, resulting in negative equity of $8,000.

What is the Debt to Equity Ratio? 🤔

Now that we’ve handled the basics, let’s move on to today’s meat of the matter – the debt to equity (D/E) ratio. This ratio provides plenty of insight into the financial health of a company by focusing on how leveraged (or indebted) it is. In essence, the D/E ratio lets investors know to what degree a business relies on debt to finance itself.

Businesses that rely a lot on debt face a variety of challenges – basically, a business like that has put itself in a position where it has a lot of fixed payments and interest to pay off – which leads to consistent and high expenses. This, in turn, makes breaking even and turning a profit more difficult. This understanding of the financing and capital structure of a business is essential for comparing competing businesses.

What Does the D/E Ratio Tell Investors? 🧐

As we’ve discussed, the main thing the debt to equity ratio lets investors know is to what degree a business is leveraged. The biggest utility of this ratio is comparing competing companies in the same industry – two businesses with similar returns and results might look just as appealing at first glance, but if one is slowly becoming more indebted over time, long-term prospects aren’t equal between the two.

In essence, the debt to equity ratio is used to assess how risky investing in a business is. However, context is king – if a business takes on debt to finance expansions and generate greater earnings and take advantage of favorable conditions for growth, then taking on debt can actually be a good thing as far as shareholders are concerned.

It all boils down to this – the debt to equity ratio is both a useful tool for risk analysis, and it is also a stepping stone toward a wider, more holistic assessment of a business’s risk profile and long-term prospects.

Granted, the D/E ratio is slightly less useful for short-term investing purposes, so traders that use approaches like swing trading, day trading, or scalping might not find it all that useful. Thankfully, there are other ratios that serve to fill this blind spot – such as the cash ratio or the current ratio.

Good vs. Bad D/E Ratio ⚔

At first glance, the lower the D/E ratio is for a company, the better. A low ratio means that a business doesn’t rely on debt to finance operations and expansion, which is generally a good thing. However, generally is the operative word here. As we’ve discussed, a higher D/E ratio doesn’t have to mean that a company is in trouble – if the debt is used to successfully increase earnings and profits.

What exactly constitutes a good or bad D/E ratio will depend chiefly on the industry that the business is in. As a rule of thumb, anything close to or preferably lower than 1 is good, with things becoming risky right around the mark of 2.

This, however, does come with a couple of footnotes. Average D/E varies greatly among different industries, so it is important to take this rule of thumb with a grain of salt and always compare businesses to their peers and competitors. Some industries, such as the financial sector, have much higher average debt to equity ratios – but we’ll cover that in more detail later in this guide.

Negative D/E Ratio 📉

As we’ve mentioned in an example above, it is possible for a company to have more liabilities than assets, which leads to negative equity. This, in turn, leads to a negative D/E ratio, which, although rare, is considered a very reliable sign that a business is in dire straits, financially.

In general, companies that have a negative D/E ratio should be given a wide-berth – the risk simply isn’t worth it. If investors have put money into stocks that have later developed a negative D/E ratio, the general recommendation is to sell the stock and reinvest it in something more stable.

Calculating the Debt-to-Equity Ratio 🧮

Alright – we’ve gone over what the D/E ratio is, what it is used for, and the like – so, how does one actually find the D/E ratio? Well, the equation itself is, thankfully, quite simple.

In order to calculate the D/E ratio of a company, investors will need two pieces of information – total debt and total (shareholders’) equity. Dividing total debt by total equity results in a number – and that number signifies the ratio.

To use a hypothetical example, let’s say a company has $5 million in debt and $2 million in shareholders’ equity would have a D/E ratio of 5/2=2.5 – which would be quite bad, as anything over 2 is considered risky.

On the other hand, a company with $3 million in debt but $6 million in shareholders’ equity would have a debt to equity ratio of 3/6 = 0.5, which would signify it as a safe investment.

How Can D/E Ratio Be Used in Investing? 💰

The debt to equity ratio can be used on its own as a measure of a company’s financial wellbeing. However, the metric has much more uses than that – and it truly shines when used in conjunction with other metrics and research tools.

Modifying the Debt-to-Equity Ratio 📝

One of the criticisms facing the D/E ratio is that while it is versatile, it isn’t detailed enough. This is due to the fact that not all debt is the same – short-term debt is both cheaper and less risky than long-term debt. On top of that, short-term debt is less affected by interest rate changes, and is less likely. Simply put, the structure and maturity of the debt in question are also important.

To answer this criticism, a lot of investors have taken to using a modified version of the D/E ratio – a long-term debt to equity ratio. It’s as simple as it sounds – everything stays the same, but only long-term debt is used for the metric.

As far as the structure of debt is concerned, generally speaking, the less long-term debt there is, the better. If two companies have the same amount of equity, and the same amount of debt, but that debt is divided differently among long-term and short-term debt, even though the D/E ratio might be the same, the risk profile of the two businesses can be quite different – with the company that has more long-term debt being the riskier one.

The D/E ratio can also be adapted for use on a smaller scale – personal finance. The only modification necessary to do so is using personal equity and debts. Investors who feel like they’re up to the task can use the metric to assess their own levels of debt, and lenders have been known to use this approach when negotiating loans for individuals or small businesses.

Common Mistakes When Using This Ratio ⚠

Although it is a simple equation, the debt to equity ratio is often misinterpreted and misused. The reason for this lies in the fact that investors often get creative with that simple equation – either by neglecting to factor in short-term debt, or not including non-interest-bearing debt under liabilities.

However, the single most common mistake that occurs when using the D/E ratio actually has nothing to do with the ratio itself – but has everything to do with the average investor’s woefully inadequate understanding of debt.

The very word debt brings up unpleasant imagery – but in the world of finance, debt isn’t necessarily a bad thing. In fact, equity is generally held to be riskier than debt – meaning that financing a company through debt isn’t always something that should be avoided. Experience has shown that there is always an optimal balance between debt and equity financing – extreme reliance on either source is a red flag.

Unlike equity, debt does not dilute ownership – meaning that more of a business’s profits stay in-house or get redistributed to existing shareholders. The payments owed on debt are known ahead of time, raising capital via debt is easier, and lenders usually expect much less in terms of returns when compared to investors.

Thankfully, these pitfalls are quite easy to avoid – although we will leave readers with a word of caution. The debt to equity ratio, like many other metrics, usually isn’t calculated manually by investors themselves – these metrics are often provided by third-party sources of research, stock screeners, and the like.

Without knowing the exact methodology used by the provider of the metric, there’s no way to gauge how accurate it is – and although it might be slightly more time-intensive, taking the time out to calculate D/E properly is worth the effort.

Calculating Shareholder Profits 💵

The debt to equity ratio can serve as a good starting point for calculating shareholder profits. In particular, the D/E ratio is an important metric for a vast majority of passive or hands-off approaches such as buy-and-hold and dividend investing.

It all boils down to one simple fact – companies that are saddled with a lot of interest payments and debt have a harder time becoming profitable. Incorporating the D/E ratio into a stock research routine will go a long way in separating the wheat from the chaff.

Of course, nothing happens in a vacuum – the D/E ratio isn’t a one-stop shop when it comes to shareholder profits. When conducting research, investors should always factor in other influences such as earnings per share, shareholder value, and others.

Financial Analysis 🔍

As we’ve discussed, the debt to equity ratio is a lens through which all sorts of financial analyses can be conducted – but broadly speaking, the D/E ratio is generally a metric of risk, and should be used to determine if an investment falls within acceptable risk tolerance.

To put it as plainly as possible, a high D/E ratio has no advantages over a low one. High ratios are usually indicative of poor management – an inability to settle a company’s debts doesn’t bode well in terms of how likely that company is to provide returns to investors. If a company is too reliant on debt to finance operations, it might have very well “run out of steam” so to say.

The most essential thing to remember when using the D/E ratio as a tool of financial analysis is that comparison and context have to be taken into account. A company with a seemingly good D/E ratio might actually be lagging behind its competitors – and in much the same way, what might seem like a bad D/E ratio can actually be a sign of well-timed expansion.

Without an overview of the average ratios in an industry, knowing where an individual company stands isn’t worth much. If one were to take things at face value, industry-leaders such as O’Reilly Automotive, Colgate Palmolive, and Marriott International would seem like horrible companies to invest in – all of them have very high D/E ratios.

The truth, however, is a little more complicated – although all of these companies are highly leveraged, their stocks have great growth potential, earnings growth, and promising signs in other areas.

Different Examples of the D/E Ratio 📜

With most of the relevant information regarding debt to equity ratios squared away, it’s time to bring the topic a little closer to home – with a couple of real-world examples that will hopefully serve to illustrate not only the basics but some of the finer points of using the debt to equity ratio as a means of analysis as well.

Twitter and Netflix 👨‍💻

Twitter’s had an interesting time in 2022 so far – with Elon Musk’s acquisition of the company dominating the news cycle. As of March 2022, Twitter’s total debt was $6.63 billion, while total shareholder equity was at $5.90 billion, for a D/E ratio of 1.12.

While that seems perfectly fine, Twitter has struggled to turn a profit – having posted losses both in 2021 and 2020. When Musk’s takeover is complete, Twitter’s interest payments will climb to $845 million per year – making an already bad situation even worse in terms of how easy it will be to break even.

Netflix received a lot of attention in early 2022 due to the well-publicized and controversial decisions to tackle the questions of password sharing and advertising. In March of 2022, the company had $14.54 billion in debt, with shareholders’ equity having risen to $17.54 billion.

Dividing 14.54 by 17.54 makes for a debt to equity ratio of 14.54/17.54=0.82, which would suggest stability and financial health – however, looking at the bigger picture, it is painfully obvious that Netflix is headed for dire straits.

Huarong 🇨🇳

On the other hand, we have the example of China’s Huarong – one of the key players in the worrying saga of Chinese real estate debt. After posting a staggering $15.9 billion loss in August of 2021 reduced shareholder equity by 85%, the D/E ratio quickly turned from bad to worse.

Although the company got a government bailout, suspended trading for nine months, and quickly became profitable again, the damage was already done – unlike with Netflix, the D/E ratio was not promising, but the situation was stabilized – but it was all in vain.

Average Debt to Equity Ratio Across Sectors and Industries 📊

Looking at the S&P 500 as a whole over the late 2010s and early 2020s, the average D/E ratio is somewhere in the ballpark of 1.6, and it doesn’t tend to move much. Unfortunately, that isn’t any sort of usable benchmark – as you’ll see in the next table, the average D/E ratios across different industries are very different.

Data is based on information from January 2022, sourced from the New York University Stern School of business.

So, with that said, does this data suggest that, say, financial services are inherently more risky than restaurants? Not at all – it is simply the fact that the ins and outs of doing business are very different when looking at almost any two industries.

Remember – the D/E ratio is used for comparison – if a company has high operating leverage, that isn’t always a sign of trouble (so long as the ratio isn’t much greater than the industry standard.

One should also keep in mind that debt isn’t static – these averages will change in the future, so staying informed and up-to-date is of the utmost importance. U.S. corporate debt has reached new heights since the outbreak of the COVID-19 pandemic, with the information technology, communication services, and healthcare sectors leading the charge on acquiring more debt.

Pros and Cons ⚖

Although it is universal in the sense of being applicable to every publicly-traded company, the debt to equity ratio does not translate well across different sectors and industries. To make a long story short, the intricacies of doing business in a variety of ways lead to the fact that there is no one-size-fits-all answer to the question of what a good D/E ratio is.

For example, companies in the finance space, banking, airlines, and utilities tend to have high D/E ratios, oftentimes exceeding 10. On the other hand, other industries such as wholesalers, the services industry, forestry, and mining tend to have lower ratios. What constitutes a “good” D/E ratio depends on industry, and the metric should always be examined in that context.

Still, this isn’t too much of a flaw – if one were to be choosing between a hypothetical bank stock and a mining stock, everything else being equal, how indebted these companies are in comparison to the average of their respective industries is still salient information.

Once all is said and done, the most important thing to remember is that the D/E ratio isn’t a silver bullet or magical solution – nothing like that exists in finance and investing. However, if used properly, in conjunction with other metrics and forms of analysis, this ratio can give investors important, actionable information that can lead to an edge over the competition.

The devil is in the details – and the other details, such as cash flow, revenues, growth forecasts, and the maturity of loans should still be considered. Other metrics such as the sharpe ratio, a stock’s beta, the price to earnings ratio, and others should also be considered.

Conclusion 🏁

That’s all there is to it regarding the debt to equity ratio. Although it is quite simple, this metric is one of the keys to understanding the state that a business is in. Decisions can’t be based solely on this ratio – of course, context matters – but the debt to equity ratio is an unavoidable piece of the puzzle.

Practice makes perfect – while looking at financial records, calculating ratios and the like might seem difficult to do, with time, it becomes second nature. Metrics like these are important both for short-term and long-term investors – so mastering their usage is essential.

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