If a company has a negative D/E ratio, this means that it has negative shareholder equity. 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.

Advantages and Disadvantages of the Debt Ratio

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. Both of these values can be found on a company’s balance sheet, which is a financial statement that details the balances for each account.

Debt Ratio: Interpreting, Calculating, and Optimizing Financial Health

This ratio compares a company’s equity to its assets, showing how much of the company’s assets are funded by equity. Ultimately, businesses must strike an appropriate balance within their industry between financing with debt and financing with sources of funding equity. The D/E ratio represents the proportion of financing that came from creditors (debt) versus shareholders (equity). The nature of the baking business is to take customer deposits, which are liabilities, on the company’s balance sheet.

What Does It Mean for a Debt-to-Equity Ratio to Be Negative?

A low D/E ratio shows a lower amount of financing by debt from lenders compared to the funding by equity from shareholders. ✝ To check the rates and terms you may qualify for, SoFi conducts a soft credit pull that will not affect your credit score. Finally, the debt-to-equity ratio does not take into account when a debt is due.

• It suggests that a company relies heavily on borrowing to fund its operations, often due to insufficient internal finances.
• A D/E ratio less than 1 means that shareholders’ equity is greater than total liabilities.
• The debt-to-equity ratio can clue investors in on how stock prices may move.
• A good D/E ratio of one industry may be a bad ratio in another and vice versa.
• This suggests that Company B has a lower level of financial risk and is less reliant on debt for financing its operations.

Total Liabilities

A high ratio indicates that a company may be at risk of default on its loans if interest rates suddenly rise. A ratio below 1 means that a greater portion of a company’s assets is funded by equity. We know that total liabilities plus shareholder equity equals total assets. Thus, shareholders’ equity is equal to the total assets minus the total liabilities. That is, total assets must equal liabilities + shareholders’ equity since everything that the firm owns must be purchased by either debt or equity.

Cons of Debt Ratio

Total debt represents the aggregate of a company’s short-term debt, long-term debt, and other fixed payment obligations, such as capital leases, incurred during normal business operations. To accurately assess these liabilities, companies often create a debt schedule that categorizes liabilities into specific components. The debt-to-equity ratio is one of several metrics that investors can use to evaluate individual stocks. At its simplest, the debt-to-equity ratio is a quick way to assess a company’s total liabilities vs. total shareholder equity, to gauge the company’s reliance on debt.

Company B is more financially stable but cannot reach the same levels of ROE (return on equity) as company A in the case of success. Determining whether a debt-to-equity ratio is high or low can be tricky, as it heavily depends on the industry. In some industries that are capital-intensive, such as oil and gas, a “normal” D/E ratio can be as high as 2.0, whereas other sectors would consider 0.7 as an extremely high leverage ratio. We have the debt to asset ratio calculator (especially useful for companies) and the debt to income ratio calculator (used for personal financial purposes). They do so because they consider this kind of debt to be riskier than short-term debt, which must be repaid in one year or less and is often less expensive than long-term debt. When interpreting the D/E ratio, you always need to put it in context by examining the ratios of competitors and assessing a company’s cash flow trends.

It’s important to note that different industries have different standards and norms for what constitutes a “healthy” D/E ratio. As such, this ratio is often most useful when comparing similar companies within the same industry. Profit and prosper with the best of Kiplinger’s advice on investing, taxes, retirement, personal finance and much more. In fact, a firm that uses its leverage to capitalize on a high-return project will likely outperform one that uses very little debt but sits in an unfavorable position in its industry, he says. Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more – straight to your e-mail. Our team is ready to learn about your business and guide you to the right solution.

Whereas, equity financing would entail the issuance of new shares to raise capital which dilutes the ownership stake of existing shareholders. Debt financing is often seen as less risky than equity financing because the company does not have to give up any ownership stake. 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.

In nutrition science, there’s a theory of metabolic typing that determines what type of macronutrient – protein, fat, carbs or a mix – you run best on. The debt-to-equity ratio is the metabolic typing equivalent for businesses. It can tell you what type of funding – debt or equity – a business primarily runs on. 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. In summary, computing the Debt to Equity ratio is essential for assessing financial health and risk. Companies should regularly evaluate their ratio to ensure it aligns with their strategic goals.