"What is a good debt to equity ratio?" is a question often asked by investors. Debt to equity ratio is a financial measure that shows the relative proportion that exists between a company's equity and its debt while operating to gain assets. Some equate an entity's debt-to-equity ratio very directly with its financial leverage.
Debt to equity ratio (sometimes written "debt-to-equity ratio" or shortened to D/E ratio) is considered a financial industry standard for assessing a company's financial health. It is also an indicator of that company's ability to repay its debts. Examining the health of any company should involve analyzing its debt to equity ratio. This is why so many budding investors focus on that question: "What is a good debt to equity ratio?"
A rising debt to equity ratio may indicate that a company is falling too far in debt to creditors rather than generating its own capital. Investors should be wary of D/E ratios that are trending upward, especially when observed in new companies or those with a poor record of performance thus far. Thus, companies with high debt-to-equity ratios may find it difficult to attract additional lending capacity or investors.
In contrast, a low D/E ratio suggests better overall financial health for a company, and therefore more internal resources to apply positively in the event of an economic downturn or substantial loss of profits. That adds up to a more stable, investment-worthy entity in most cases.
What Happens with a High Debt to Equity Ratio?
Broadly speaking, companies with high debt to equity ratios have these two things in common:
- The high debt to equity ratio is problematic and can threaten financial insolvency and bankruptcy if the company ultimately cannot pay its bills and service all that debt. Investors may be at risk for losses due to a collapse in the stock price or other consequences.
- The potential positive side of a high debt to equity ratio is that it might mean greater, more rapid growth opportunities. Companies that use the borrowed capital for strategic expansions in production and distribution could reap big returns, for example. Higher debt doesn't mean higher risk alone. Higher levels of debt can be favorable if the company invests in growth strategies wisely.
Another way to test what is a good D/E ratio is to look further into a company’s funding of its growth with debt. Companies that rely on outside resources or external funding to provide growth opportunities should be viewed with caution. Debt levels higher than the market or industry average can create high-interest payments that put creditworthiness and future earnings at risk. Lower D/E ratios are certainly positive in terms of stability, but investors may not see the returns that more heavily leveraged firms pay out when they invest and bet well.
We keep piling up reasons you should always have the question "What is a good debt to equity ratio?" in mind. Next, let's consider how we should look at companies that appear financially healthy by this measure.
What Happens with a Low Debt to Equity Ratio?
On the other side of the equation that we're working with here, two major considerations apply to companies exhibiting a low debt to equity ratio:
- Investors that are interested in lower risks and moderate outcomes should look for this train in their target companies. You generally play it safe by selecting a company that keeps its D/E ratio low.
- Another scenario commonly found with larger companies are operating on smaller gains and assets or liquidating them and returning profits back to its owners or shareholders. Companies such as these do not pay large dividends but do not go out of business often either.
There is no accepted, final answer to the question of what is a good debt to equity ratio. Investors must always use sound judgment and counsel from a financial professional to analyze a company's overall well-being and potential, including its D/E ratio. Many top investors will be more forgiving of higher debt to equity ratios because they want some risk in their portfolios. This willingness depends on companies' other financial indicators, however.
How to Calculate & Evaluate a D/E Ratio
Determining what is a good debt to equity ratio takes research and financial planning best accomplished by professionals. Many use this common debt to equity ratio equation: Debt to equity ratio = (short-term debt + long-term debt + fixed payment obligations) / shareholders’ equity.
Here, debt includes both short-term and long-term liabilities, but the equation itself allows you to consider them separately. There are many types of short-term debt, including short-term loans, in-and-out funds, noted payables, and even longer-term loan interest payments. The overall equity of a company can also include balance sheet items such as ordinary share, preferred share, keep earnings, and comprehensive income.
Calculations such as those associated with D/E ratio create a financial roadmap for investors. They allow us to see the levels of risk associated with companies and judge their overall financial stability based on all that we know. Because there are huge differences between industries, investors should be familiar with the applicable industry standards in each case. For example, some industries have high margins of profit and tend to maintain differing amounts of capital from others. A higher debt-to-equity ratio makes more sense in some commercial endeavors.
Be aware that creditors commonly use this ratio to limit a particular company's borrowing ability and prevent it from becoming over-leveraged. Lenders and investors can stipulate that the company borrowing money must not exceed a certain debt-to-equity ratio in what is called a debt covenant. This is to protect lenders and investors from incurring too much risk.
What Is a Good Debt to Equity Ratio... Really?
Calculating what is a good debt-to-equity ratio often requires researching the specific companies within a specific industry to determine if their results warrant seeking more information.
Risks for Investors
As we've discussed, debt to equity ratio can be a useful barometer of risk for investors. Long-term debt strategies in a healthy economy make perfect sense since interest rates are low. However, rising interest rates or spending borrowed capital that is not fixed at a fixed rate can create surprises for both the company and investor. Obviously, over-leveraging can sour a company's future profitability if debt payments become overwhelming and profits don't keep pace.
Markets tend to keep corporations honest by allowing investors to react to bond investment ratings. Triple-A rated bonds pay the lowest rate of interest. These are associated with higher-performing companies that have a better-than-average track record of profitability and exhibit lower risk factors. At the other end of the spectrum, junk bonds usually offer the highest interest costs due to the increased probability of default.
Debt, Interest Payments, & Potential Insolvency
What is a good debt to equity ratio's relationship to interest? What if that number is a high one instead? D/E ratio factors heavily into the company's fixed interest payments as well as its credit standing. Defaulting on loans can lead bankruptcy or leveraged buyouts that can leave investors with nothing. Even a few missed payments can incur millions in legal costs and a poor reputation for the company's future. Good research can show the history of these payments, not only with the specific company being considered for investment but other similar companies within the same industry.
One final factor in considering companies for investment is whether insolvency or bankruptcy may force a firm to sell off assets, ranging from hard assets such as real estate to soft, but critical, assets such as patents. Newer companies don't have the advantage of legacy cash or investment reserves. Since they have fewer hard assets, a bankruptcy might require them to sell intellectual property, which can destroy their competitive advantage.
Debt on a company’s balance sheet is a visualization of financial obligations the company must be able to meet in order to continue operating. Calculating what is a good debt to equity ratio helps company management, lenders, and creditors understand the riskiness of the company's financial structure. This ratio offers insight into the company's financing decisions and the probability of the business being able to finance its growth well.
One more time, then: What is a good debt to equity ratio? Well, the answer will always depend on the industry and specific situation. Companies that have a debt-to-equity ratio greater than 1.0 have more debt than equity. Any company with a debt to equity ratio that high could be the focus of leveraged buyouts or other events that may affect performance, value, and even the continued viability of the company. That's why we primarily look for the better D/E ratios.