Companies use a mix of debt and equity to finance their operations. While the cost of debt is typically less than investors' required return on equity, prudent financial management limits the amount of debt a company can support. One measure of the financial health of a company is its ratio of debt to equity.

What is the Debt-to-Equity Ratio?

Financial analysts calculate a company's liabilities-to-equity ratio by dividing its total debt by the total equity capitalization.

Consider this example of the Hasty Hare Corporation, a manufacturer of sneakers for rabbits. The balance sheet of Hasty Hare shows the following liabilities:

  • Accounts payable: $107,000
  • Deferred revenues: $18,000
  • Accrued expenses: $31,000
  • Short-term loans: $175,000
  • Current maturities long-term debt: $67,000
  • Long-term debt: $225,000
  • Notes payable (matures in more than one year): $87,000
  • Total Liabilities: $710,000
  • Total Equity: $805,000

The debt-to-equity ratio formula for Hasty Hare is:

Total Liabilities/Total Equity = $710,000/$805,000 = 0.88

How to Interpret Total Debt-to-Equity Ratio

While business managers want some financial ratios, such as profit margins, to be as high as possible, debt-to-equity ratios need to fall within a certain range.

A high debt-to-equity ratio may be a flag that the company has financial problems and could have difficulty meeting its debt payment obligations. Conversely, a low debt-to-equity ratio indicates that the company is placing too much reliance on equity to finance its operations. Companies with low debt-to-equity ratios are vulnerable targets for leveraged buyouts by outside investors.

What is a Good Debt-to-Equity Ratio?

A good debt-to-equity ratio depends on the industry. Large manufacturing companies with significant investments in fixed assets tend to have debt-to-equity ratios of less than 2. At the other extreme, banks or other financial institutions and utilities have ratios upwards of 6 and even above 10.

Industries that have more predictable and stable cash flows can handle higher debt-to-equity ratios. Most public utilities have a monopoly in their regions and don't have to worry about losing market share to a competitor.

What are the Advantages of Debt?

Incurring debt is a way for a company to leverage its equity and obtain cheaper funds for expansion. Businesses that borrow money are able to take advantage of market opportunities more quickly to grow and expand.

A company that does not take advantage of its borrowing capacity may be short-changing its shareholders by limiting the opportunities of the business to generate additional profits. Furthermore, interest on the debt is tax-deductible while dividends paid to investors is not.

What are the Disadvantages of Debt?

Lenders see a higher debt-to-equity ratio as risky because it reveals that investors don't have as much money in the business as the creditors. This could indicate a lack of confidence by the investors. Creditors view businesses with low debt-to-equity ratios as less likely to default on their debts.

Higher debts mean that the company has more fixed obligations to meet. Equity investors hope to receive dividends, but lenders expect to receive their interest and principal payments on the planned due dates without fail.

The debt-to-equity ratio is not necessarily the final determinant of financial risk because it does not disclose when the debts are to be repaid. A company with a seemingly high debt-to-equity ratio that has most of its debt as long-term is less risky than another company with the same debt-to-equity ratio, but with mostly short-term debts.

How Does Debt Affect Return on Equity?

Maintaining an appropriate amount of debt is a prudent tactic for management because it can increase shareholders' return on equity. Consider the following example.

This is the relevant data from the balance sheet and income statement of the Hasty Hare Corporation without any debt:

  • Revenue: $1,000,000
  • Cost of goods sold: $600,00
  • Administrative expenses: $200,000
  • Interest expense: $0
  • Pre-tax profit: $200,000
  • After-tax profit: $130,000
  • Total assets: $2,000,000
  • Liabilities: $0
  • Shareholders' equity: $200,000
  • Return on equity: 6.5 percent

Now, suppose that the company adds $100,000 in debt to replace the same amount of equity. These are the figures after adding the debt:

  • Revenue: $1,000,000
  • Cost of goods sold: $600,00
  • Administrative expenses: $200,000
  • Interest expense: $30,000
  • Pre-tax profit: $170,000
  • After-tax profit: $110,500
  • Total assets: $2,000,000
  • Liabilities: $1,000,000
  • Shareholders' equity: $1,000,000
  • Return on equity 11.05 percent

In this case, the return on equity increased from 6.5 percent to 11.05 percent as a result of using more debt.

Managing the debt-to-equity ratio is a balancing act to control the risk and maximize the return to shareholders.