What Is a Good Debt-to-Equity Ratio and Why It Matters (2024)

The debt-to-equity ratio (D/E) is a financial leverage ratio that can be helpful when attempting to understand a company's economic health and if an investment is worthwhile or not. It is considered to be a gearing ratio that compares the owner's equity or capital to debt, or funds borrowed by the company.

This ratio compares a company's total liabilities to its shareholder equity. It is widely considered one of the most important corporate valuation metrics because it highlights a company's dependence on borrowed funds and its ability to meet those financial obligations.

Because debt is inherently risky, lenders and investors tend to favor businesses with lower D/E ratios. For lenders, a low ratio means a lower risk of loan default. For shareholders, it means a decreased probability of bankruptcy in the event of an economic downturn. A company with a higher ratio than its industry average, therefore, may have difficulty securing additional funding from either source.

Key Takeaways

  • Thedebt-to-equityratio is a financial leverage ratio, which is frequently calculated and analyzed, that compares a company's total liabilities to itsshareholder equity.
  • The D/E ratio is considered to be a gearing ratio, a financial ratio that compares the owner's equity or capital to debt, or funds borrowed by the company.
  • The debt-to-equity ratio is calculated by dividing a corporation's total liabilities by its shareholder equity.
  • The optimalD/E ratio varies by industry, but it should not be above a level of 2.0.
  • A D/E ratio of 2 indicates the company derives two-thirds of its capital financing from debt and one-third from shareholderequity.

What Is a Good Debt-to-Equity Ratio?

The optimal debt-to-equity ratio will tend to vary widely by industry, but the general consensus is that it should not be above a level of 2.0. While some very large companies in fixed asset-heavy industries (such as mining or manufacturing) may have ratios higher than 2, these are the exception rather than the rule.

The debt-to-equity ratio often is associated with risk: A higher ratio suggests higher risk and that the company is financing its growth with debt. However, when a company is in its growth phase, a high D/E ratio might be necessary for that growth.

A D/E ratio of 2 indicates that the company derives two-thirds of its capital financing from debt and one-third from shareholder equity, so it borrows twice as much funding as it owns (2 debt units for every 1 equity unit). A company's management will, therefore, try to aim for a debt load that is compatible with a favorable D/E ratio in order to function without worrying about defaulting on its bonds or loans.

Why Debt Capital Matters

A business that ignores debt financing entirely may be neglecting important growth opportunities. The benefit of debt capital is that it allows businesses to leverage a small amount of money into a much larger sum and repay it over time. This allows businesses to fund expansion projects more quickly than might otherwise be possible, theoretically increasing profits at an accelerated rate.

A company that does not make use of the leveraging potential of debt financing may be doing a disservice to the ownership and its shareholders by limiting the ability of the company to maximize profits.

The interest paid on debt also is typically tax-deductible for the company, while equity capital is not. Debt capital also usually carries a lower cost of capital than equity.

Role of Debt-to-Equity Ratio in Company Profitability

When looking at a company's balance sheet, it is important to consider the average D/E ratios for the given industry, as well as those of the company's closest competitors, and that of the broader market.

If a company has a D/E ratio of 5, but the industry average is 7, this may not be an indicator of poor corporate management or economic risk. There also are many other metrics used in corporate accounting and financial analysis used as indicators of financial health that should be studied alongside the D/E ratio.

Is a Higher or Lower Debt-to-Equity Ratio Better?

In general, a lower D/E ratio is preferred as it indicates less debt on a company's balance sheet. However, this will also vary depending on the stage of the company's growth and its industry sector. Newer and growing companies often use debt to fuel growth, for instance. D/E ratios should always be considered on a relative basis compared to industry peers or to the same company at different points in time.

What Type of Ratio Is the Debt-to-Equity Ratio?

The D/E ratio can be classified as a leverage ratio (or gearing ratio) that shows the relative amount of debt a company has. As such, it is also a type of solvency ratio, which estimates how well a company can service its long-term debts and other obligations. This is in contrast to a liquidity ratio, which considers the ability to meet short-term obligations.

What Does a High Debt-to-Equity Ratio Mean?

For a mature company, a high D/E ratio can be a sign of trouble that the firm will not be able to service its debts and can eventually lead to a credit event such as default. For a growing company, a high D/E could be a healthy sign of expansion. In all cases, D/E ratios should be considered relative to a company's industry and growth stage.

Why Is Debt-to-Equity Ratio Important?

If a company cannot pay the interest and principal on its debts, whether as loans to a bank or in the form of bonds, it can lead to a credit event. In the event of a default, the company may be forced into bankruptcy. The D/E ratio is one way to look for red flags that a company is in trouble in this respect.

The Bottom Line

Debt-to-equity is a gearing ratio comparing a company's liabilities to its shareholder equity. Typical debt-to-equity ratios vary by industry, but companies often will borrow amounts that exceed their total equity in order to fuel growth, which can help maximize profits. A company with a D/E ratio that exceeds its industry average might be unappealing to lenders or investors turned off by the risk. As well, companies with D/E ratios lower than their industry average might be seen as favorable to lenders and investors.

What Is a Good Debt-to-Equity Ratio and Why It Matters (2024)

FAQs

What Is a Good Debt-to-Equity Ratio and Why It Matters? ›

Generally, a good debt-to-equity ratio is anything lower than 1.0. A ratio of 2.0 or higher is usually considered risky. If a debt-to-equity ratio is negative, it means that the company has more liabilities than assets—this company would be considered extremely risky.

Why is a good debt-to-equity ratio important? ›

The debt-to-equity ratio often is associated with risk: A higher ratio suggests higher risk and that the company is financing its growth with debt. However, when a company is in its growth phase, a high D/E ratio might be necessary for that growth.

Is 0.5 a good debt-to-equity ratio? ›

Generally, a lower ratio is better, as it implies that the company is in less debt and is less risky for lenders and investors. A debt-to-equity ratio of 0.5 or below is considered good.

Is a debt-to-equity ratio of 50% good? ›

Yes, a D/E ratio of 50% or 0.5 is very good. This means it is a low-debt business and the company's equity is twice as high as its debts.

What does a debt-to-equity ratio of 2.5 mean? ›

The ratio is the number of times debt is to equity. Therefore, if a financial corporation's ratio is 2.5 it means that the debt outstanding is 2.5 times larger than their equity. Higher debt can result in volatile earnings due to additional interest expense as well as increased vulnerability to business downturns.

What makes a good debt ratio? ›

If your debt ratio does not exceed 30%, the banks will find it excellent. Your ratio shows that if you manage your daily expenses well, you should be able to pay off your debts without worry or penalty. A debt ratio between 30% and 36% is also considered good.

Why is debt to ratio important? ›

Your debt-to-income ratio (DTI) is all your monthly debt payments divided by your gross monthly income. This number is one way lenders measure your ability to manage the monthly payments to repay the money you plan to borrow. Different loan products and lenders will have different DTI limits.

What is a really bad debt-to-equity ratio? ›

What is a bad debt-to-equity ratio? When the ratio is more around 5, 6 or 7, that's a much higher level of debt, and the bank will pay attention to that. “It doesn't mean the company has a problem, but you have to look at why their debt load is so high,” says Lemieux.

Why is a 1.2 debt-to-equity ratio good? ›

With a debt to equity ratio of 1.2, investing is less risky for the lenders because the business is not highly leveraged — meaning it isn't primarily financed with debt.

Is 4.5 a good debt-to-equity ratio? ›

The maximum acceptable debt-to-equity ratio for more companies is between 1.5-2 or less.

How to interpret debt-to-equity ratio? ›

Your ratio tells you how much debt you have per $1.00 of equity. A ratio of 0.5 means that you have $0.50 of debt for every $1.00 in equity. A ratio above 1.0 indicates more debt than equity. So, a ratio of 1.5 means you have $1.50 of debt for every $1.00 in equity.

What is Google's debt-to-equity ratio? ›

The D/E ratio compares a company's total debt to its equity. A value under 100% is good. As of the end of the 2019 fiscal year, Google's D/E ratio was 0.08, indicating an extremely low debt load compared to its equity. In fact, over the 15-year period from 2005-2020, Google's D/E ratio has never risen above 10%.

What is a generally acceptable debt-to-equity ratio? ›

The ideal debt to equity ratio is 2:1. This means that at no given point of time should the debt be more than twice the equity because it becomes riskier to pay back and hence there is a fear of bankruptcy.

What is the debt-to-equity ratio of JP Morgan? ›

JPMorgan Chase Debt to Equity Ratio: 1.885 for March 31, 2024.

What is the debt-to-equity ratio of Apple? ›

31, 2023.

What is a good debt-to-equity ratio for a family? ›

The ideal debt to equity ratio, using the formula above, is less than 10% without a mortgage and less than 36% with a mortgage. If you exceed 36%, it is very easy to get into debt. Most lenders hesitate to lend to someone with a debt to equity/asset ratio over 40%.

What is the importance of debt ratio for investors? ›

Generally speaking, companies with a high debt-to-equity ratio may be at a greater financial risk than those with a low one, and this can affect how attractive their stock is to investors. The ratio is most meaningful when comparing two or more stocks in the same industry and growth stage.

Should debt-to-equity ratio be positive or negative? ›

Negative D/E Ratio → A negative D/E ratio means the company in question has more debt than assets. Positive D/E Ratio → A positive D/E ratio, on the other hand, implies the company has more assets than debt.

Why is it better to have more debt than equity? ›

Debt financing may have more long-term financial benefits than equity financing. With equity financing, investors will be entitled to profits, and if you sell the company, they'll get some of the proceeds too. This reduces the amount of money you could earn by owning the company outright.

What is the importance of debt to asset ratio? ›

The debt-to-total assets ratio is primarily used to measure a company's ability to raise cash from new debt. That evaluation is made by comparing the ratio to other companies in the same industry. The higher a company's debt-to-total assets ratio, the more it is said to be leveraged.

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