In most cases, this would be considered a sign of high risk and an incentive to seek bankruptcy protection. What counts as a “good” debt-to-equity (D/E) ratio will depend on the nature of the business and its industry. Generally speaking, a D/E ratio below 1 would be seen as relatively safe, whereas values of 2 or higher might be considered risky. Companies in some industries, such as utilities, consumer staples, and banking, typically have relatively high D/E ratios.
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There are various companies that rely on debt financing to grow their business. For example, Nubank was backed by Berkshire Hathaway with a $650 million loan. A good D/E ratio also varies across industries since some companies require more debt to finance their operations than others.
Step 1: Identify Total Debt
An investment firm is evaluating two companies, Company X and Company Y, operating in different industries. Company X is a telecommunications company with a debt-to-equity ratio of 1.5, while Company Y is a consumer goods company with a debt-to-equity ratio of 0.8. In considering debt/Equity ratios it is important to look on hello fans of xero personal a Net basis, i.e. subtracting cash on the balance sheet from the debt figure, as well as looking on a gross basis. Many large companies operate with substantial cash balances, so the “gross” ratio can overstate the risk. In summary, computing the Debt to Equity ratio is essential for assessing financial health and risk.
- Companies in some industries, such as utilities, consumer staples, and banking, typically have relatively high D/E ratios.
- Over this period, their debt has increased from about $6.4 billion to $12.5 billion (2).
- Anything you have to pay back – even that unofficial loan from a mate – is classified as being part of your business’s debt obligations.
Financial Ratios Similar to the Debt-to-Equity Ratio
However, if the cost of debt interest on financing turns out to be higher than the returns, the situation can become unstable and lead, in extreme cases, to bankruptcy. We have the debt to asset ratio calculator (especially useful for companies) and the debt to income ratio calculator (used for personal financial purposes). For instance, utility companies often exhibit high D/E ratios due to their capital-intensive nature and steady income streams.
What Does It Mean for a Debt-to-Equity Ratio to Be Negative?
And a high debt-to-equity ratio can limit a company’s access to borrowing, which could limit its ability to grow. The interest rates on business loans can be relatively low, and are tax deductible. That makes debt an attractive way to fund business, especially compared to the potential returns from the stock market, which can be volatile. The depository industry (banks and lenders) may have high debt-to-equity ratios.
This is helpful in analyzing a single company over a period of time and can be used when comparing similar companies. It is important to note that the D/E ratio is one of the ratios that should not be looked at in isolation but with other ratios and performance indicators to give a holistic view of the company. If the D/E ratio gets too high, managers may issue more equity or buy back some of the outstanding debt to reduce the ratio. Conversely, if the D/E ratio is too low, managers may issue more debt or repurchase equity to increase the ratio. A good D/E ratio of one industry may be a bad ratio in another and vice versa.
If you want to express it as a percentage, you must multiply the result by 100%. To get a sense of what this means, the figure needs to be placed in context by comparing it to competing companies. Our writing and editorial staff are a team of experts holding advanced financial designations and have written for most major financial media publications. Our work has been directly cited by organizations including Entrepreneur, Business Insider, Investopedia, Forbes, CNBC, and many others.
In this situation, the debt-to-equity ratio would not be meaningful because the denominator (equity) is negative. A negative debt-to-equity ratio would also not be meaningful because it would indicate that the company has more debt than equity, which is not possible. 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. A challenge in using the D/E ratio is the inconsistency in how analysts define debt. Therefore, comparing D/E ratios across different industries should be done with caution, as what is normal in one sector may not be in another.