What Is Considered A High Debt-To-Equity Ratio?
Though firms in the financial industry and capital-intensive sectors tend to have higher debt-to-equity ratios, there is no concrete value to be deemed a “high” ratio. When a company uses debt to finance much of its growth, the debt-to-equity ratio could be higher. Watch this video to learn more about high debt-to-equity ratios.
Reviewed by David KindnessReviewed by David Kindness
The debt-to-equity (D/E) ratio is a leverage ratio that shows how much a company’s financing comes from debt or equity. A higher D/E ratio means that more of a company’s financing is from debt versus issuing shares of equity. Banks tend to have higher D/E ratios because they borrow capital in order to lend to customers. They also have substantial fixed assets, i.e., local branches, for example.
Calculating the D/E Ratio
The D/E ratio is calculated as total liabilities divided by total shareholders’ equity. For example, if, as per the balance sheet, the total debt of a business is worth $60 million and the total equity is worth $130 million, then the debt-to-equity is 0.46. In other words, for every dollar in equity, the firm has 46 cents in leverage. A ratio of 1 indicates that creditors and investors are balanced with respect to the company’s assets. The D/E ratio is considered a key financial metric because it indicates potential financial risk.
The D/E Ratio and Risk
A relatively high D/E ratio commonly indicates an aggressive growth strategy by a company because it has taken on debt. For investors, this means potentially increased profits with a correspondingly increased risk of loss. If the extra debt that the company takes on enables it to increase net profits by an amount greater than the interest cost of the additional debt, then the company should deliver a higher return on equity (ROE) to investors. However, a company with a high debt-to-equity ratio and a high return on equity is still seen as a more risky and less desirable investment than a company achieving the same return on equity with less debt.
However, if the interest cost of the extra debt does not lead to a significant increase in revenues, the additional debt burden would reduce the company’s profitability. In a worst-case scenario, it could overwhelm the company financially and result in insolvency and eventual bankruptcy.
What Level of Debt-to-Equity Is Considered Desirable?
A high debt-to-equity ratio is not always detrimental to a company’s profits. If the company can demonstrate that it has sufficient cash flow to service its debt obligations and the leverage is increasing equity returns, that can be a sign of financial strength. However, not all high debt-to-equity and high return on equity companies are so successful. Taking on more debt and increasing the D/E ratio boosts the company’s ROE. Using debt instead of equity means that the equity account is smaller and the return on equity is higher. The inflating of the return on equity metric by high debt, can hide problems within a company. A high ROE alone doesn’t make a company a good investment. Other metrics must be examined to determine the health of the company.
Note
Bank of America’s D/E ratio for the three months ending March 31, 2019, was 0.96. In March 2009, during the financial crisis, the ratio reached 2.65, according to Macrotrends.
Typically, the cost of debt is lower than the cost of equity. Therefore, another advantage in increasing the D/E ratio is that a firm’s weighted average cost of capital (WACC), or the average rate that a company is expected to pay its security holders to finance its assets, goes down.
Overall, however, a D/E ratio of 1.5 or lower is considered desirable, and a ratio higher than 2 is considered less favorable. D/E ratios vary significantly between industries, so investors should compare the ratios of similar companies in the same industry.
In the banking and financial services sector, a relatively high D/E ratio is commonplace. Banks carry higher amounts of debt because they own substantial fixed assets in the form of branch networks.
Read the original article on Investopedia.