One of the most commonly used ratios for investors is the debt-to-equity ratio. Used along with other ratios and financial data, the debt-to-equity ratio helps investors and market analysts determine the health of a company. Because of the differences between industries, a good or bad ratio is hard to define, but within a specific industry, such as the manufacturing industry, the concept is more easily discussed.
Debt to Equity Ratio
The debt-to-equity ratio, as the name suggests, measures the relative contribution of shareholder equity and corporate liability to a company's capital. The calculation for the industry is straightforward and simply requires dividing total debt by total equity. For example, if a company is financed by $4 billion in debt and $2 billion in shareholder equity, it would have a debt-equity ratio of 2:1.
One of the most important factors that affect a company's debt-equity ratio is the stability of sales. If a company, such as a utility company, has fairly constant sales, it will tend to have a higher debt-to-equity ratio because it is not overly concerned about a downturn causing it to default on debt payments. Another important factor is profitability. If an industry or company has very high profitability, it will opt to use more debt financing because it can use debt to leverage the positive return on equity.
Manufacturing Industry Overall
While there is significant variation within the manufacturing industry, it can be observed in general that manufacturing companies, particularly those involved in heavy manufacturing, tend to have fairly high levels of operating leverage, meaning their cost structure relies heavily on fixed costs such as plant and equipment, as opposed to variable costs such as labor and raw materials. A debt-to-equity ratio of 3:1 would not be uncommon in the manufacturing sector; however, the majority of manufacturing companies have lower debt-to-equity ratios and can go to 1:6 or lower.
Differences Within Manufacturing
A great deal of variation can occur within manufacturing, largely due to variations in the markets for the products being manufactured and the capital intensity of the business model. For example, the tire, airline and automotive industries all have debt-to-equity ratios near 2:1. They do not have a great deal of variability in their sales and also are very capital intensive. On the other hand, industries such as apparel and footwear manufacturing have debt-to-equity ratios well below 1:1. These industries are very labor intensive, meaning they have low operating leverage and can also be very cyclical in terms of consumer demand.
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