Investment word of the day: Debt-to-equity ratio — what is a good D/E ratio and why does it matter?

Investment word of the day: It is important to assess a company’s financial health, ability to take risks, and growth potential before making investment decisions. One way to check a company’s financial health is to check its debt-to-equity ratio.

What is debt-to-equity ratio?

The debt-to-equity ratio (D/E ratio) is a financial metric that determines the relationship between borrowed money and the total money invested in a company. It compares the company’s total debt to its total equity.

How do you calculate debt-to-equity ratio?

The debt-to-equity ratio is calculated by dividing the total liabilities of a company by the total equity of shareholders.

The formula to calculate the D/E ratio is —  Total Liabilities / Shareholder’s Equity.

This ratio helps us understand a company’s financing strategy by showing whether the company is using equity or debt for its operations.

What is a good D/E ratio?

A high D/E ratio shows that a company uses more borrowing to fund its finances than equity. It potentially shows that the company lacks the finances to run its operations. Hence, it is often considered a risk.

A low D/E ratio shows that a company uses shareholder equity more to finance its activities than debt. It reflects that a company has its own capital than borrowed funds.

However, the risks associated with a high or low debt-to-equity ratio will depend on several other factors such as industry, strategic plans of the company, market conditions, etc. A high DE ratio may be common in some industries, not potentially reflecting high risks, while a low DE ratio may be common in others.

In capital-intensive industries such as manufacturing, oil and gas production, aviation, etc, a high D/E ratio is fairly common, whereas the service and technology sector with comparatively lesser capital requirements may have a low ratio.

The D/E ratio is a key metric for investors, creditors, and company management to figure out a company’s financial health and risk. However, this ratio must not be considered in isolation to determine the true financial performance of a company. Other key metrics such as gross profit margin, working capital, cash flow, and return on assets must also be taken into account.