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The debt-to-equity (D/E) ratio is a financial metric that measures how a company is financing its operations: through debt (borrowed money) or through equity (shareholder investment). The ratio is calculated by dividing the company's total liabilities by its shareholder equity. A high D/E ratio means the company is using debt to fund its growth, and a low D/E ratio means the company is relying on equity.
The metric is used by investors to assess the company's financial leverage and the company's risk of default. The company with a high D/E ratio is more exposed to interest rate changes, to a downturn in the business, and to the risk of bankruptcy. The company with a low D/E ratio is more conservatively financed, and the company is less exposed to the debt service cost.
What the ratio tells you
A D/E ratio of 1 means the company has equal amounts of debt and equity. A ratio of 2 means the company has twice as much debt as equity. A ratio of 0.5 means the company has half as much debt as equity. The ratio varies by industry, and the "good" or "bad" ratio depends on the industry's average.
A utility company (stable cash flows, predictable revenue) can sustain a higher D/E ratio than a technology company (volatile cash flows, uncertain revenue). The D/E ratio should be compared to the industry average, not to an absolute threshold.
The D/E ratio also tells you the company's financial leverage. A company with a D/E ratio of 2 has twice as much debt as equity, and the company is using the borrowed money to amplify the return on equity. The financial leverage works the same way as margin leverage in a trading account: it amplifies both the upside and the downside.
How to calculate it
The D/E ratio is total liabilities divided by shareholder equity. Total liabilities include both short-term debt (due within one year) and long-term debt (due after one year). Shareholder equity is the difference between the company's total assets and total liabilities.
A company with €500 million in total liabilities and €250 million in shareholder equity has a D/E ratio of 2 (€500 million / €250 million). A company with €100 million in total liabilities and €500 million in shareholder equity has a D/E ratio of 0.2 (€100 million / €500 million). The first company has high financial leverage; the second company has low financial leverage.
The industry variation
The average D/E ratio varies significantly by industry. The financial sector (banks, insurance companies, investment firms) has the highest D/E ratios, because the industry's business model is based on borrowing and lending. A bank with a D/E ratio of 10 is normal; a bank with a D/E ratio of 2 would be under-leveraged.
The technology sector has the lowest D/E ratios, because the companies generate cash from operations and do not need debt to fund growth. A technology company with a D/E ratio of 0.1-0.3 is typical; a technology company with a D/E ratio above 1 is considered highly leveraged.
The industrial sector and the utility sector fall in between, with typical D/E ratios of 1-2 for industrials and 2-4 for utilities. The variation is driven by the capital intensity of the industry and the stability of the cash flows.
The limitations of the ratio
The D/E ratio has two significant limitations. The first is that the ratio uses book values (the values on the balance sheet), not market values (the values the market assigns to the assets and the equity). A company with a well-valued brand and a strong market position may have a low book equity and a high D/E ratio, even though the company's true financial position is stronger.
The second is that the ratio does not distinguish between good debt and bad debt. A company that borrows money to invest in a high-return project (a factory expansion, a new product line, an acquisition) has a D/E ratio that is temporarily elevated, but the debt is productive. A company that borrows money to pay the dividend or to cover the operating losses has a D/E ratio that is elevated for a destructive reason.
How to use the ratio in stock trading
The trader who is evaluating a stock should check the D/E ratio as one of several metrics, alongside the earnings, the revenue growth, the profit margin, and the free cash flow. The D/E ratio that is significantly above the industry average is a red flag, and the trader should investigate the reason for the high leverage.
The trader who is considering a leveraged position in a high-D/E stock should be cautious, because the company's financial leverage amplifies the stock's volatility. A small decline in the revenue or a small rise in the interest rate can have a large impact on the earnings of a high-D/E company, and the earnings impact is reflected in the stock price.
Related resources
Where to start
If you are evaluating a company's D/E ratio, the most useful first step is to compare the ratio to the industry average and to the company's historical trend. Our broker comparison lists the research tools and the screeners at each broker, which together tell you what the financial data looks like before you make the trade.