The debt-to-equity (D/E) ratio is a leverage ratio that shows how much a company's financing comes from debt or equity. A higher D/E ratio means that more of a company's financing is from debt versus issuing shares of equity. Banks may be able to operate healthily with a slightly elevated debt to equity ratio, particularly banks with a lot of fixed assets such as those with a large branch network. The industries with the highest debt-to-equity ratios tend to be those requiring large capital expenditures and infrastructure investment such as energy production, telecommunications, and utilities.
Calculating the D/E Ratio
The D/E ratio is calculated as total liabilities divided by total shareholders' equity. For example, if, as per thebalance sheet, the total debt of a business is worth $60 million and the total equity is worth $130 million, then the debt-to-equity is 0.46. In other words, for every dollar in equity, the firm has 46 cents in leverage. A ratio of 1 indicates that creditors and investors are balanced with respect to the company’s assets. The D/Eratio is considered a key financial metric because it indicates potential financial risk.
The D/E Ratio and Risk
A relatively high D/E ratio commonly indicates an aggressive growth strategy by a company because it has taken on debt. For investors, this means potentially increased profits with a correspondingly increased risk of loss. If the extra debt that the company takes on enables it to increase net profits by an amount greater than the interest cost of the additional debt, then the company should deliver a higher return on equity (ROE) to investors. However, a company with a high debt-to-equity ratio and a high return on equity is still seen as a more risky and less desirable investment than a company achieving the same return on equity with less debt.
However, if the interest cost of the extra debt does not lead to a significant increase in revenues, the additional debt burden would reduce the company's profitability. In a worst-case scenario, it could overwhelm the company financially and result in insolvency and eventual bankruptcy.
What Level of Debt-to-Equity Is Considered Desirable?
A high debt-to-equity ratio is not always detrimental to a company's profits. If the company can demonstrate that it has sufficient cash flow to service its debt obligations and the leverage is increasing equity returns, that can be a sign of financial strength. However, not all high debt-to-equity and high return on equity companies are so successful. Taking on more debt and increasing the D/E ratio boosts the company’s ROE.Using debt instead of equity means that the equity account is smaller and the return on equity is higher. The inflating of the return on equity metric by high debt, can hide problems within a company. A high ROE alone doesn't make a company a good investment. Other metrics must be examined to determine the health of the company.
Bank of America's D/E ratio for the first quarter of 2024 was1.01. This is considered a healthy debt-to-equity ratio. In the first quarter of 2010, coming out of the financial crisis, the ratio reached 2.23.
Typically, the cost of debt is lower than thecost of equity. Therefore, another advantage in increasing the D/E ratio is that a firm’s weighted average cost of capital (WACC), or the average rate that a company is expected to pay its security holders to finance its assets, goes down.
Overall, however, a D/E ratio of 1.5 or lower is considered desirable, and a ratio higher than 2 is considered less favorable. D/E ratios vary significantly between industries, so investors should compare the ratios of similar companies in the same industry.
In the banking industry a relatively high D/E ratio is acceptable in some situations. Banks with a lot of fixed assets such as those with a large branch network tend to carry slightly elevated amounts of debt in a healthy way.
FAQs
Overall, however, a D/E ratio of 1.5 or lower is considered desirable, and a ratio higher than 2 is considered less favorable. D/E ratios vary significantly between industries, so investors should compare the ratios of similar companies in the same industry.
What debt-to-equity ratio is good for banks? ›
Industry-wise Debt to Equity Ratio
| Industry | Typical Debt to Equity Ratio Range |
|---|
| Financial Services (Banks) | 4.0 – 8.0 |
| Telecommunications | 1.0 – 2.5 |
| Industrial Manufacturing | 0.4 – 1.0 |
| Consumer Discretionary (Retail) | 0.5 – 1.5 |
14 more rowsAug 9, 2023
Generally, a good debt ratio for a business is around 1 to 1.5. However, the debt-to-equity ratio can vary significantly based on the business's growth stage and industry sector. For example, newer and expanding companies often utilise debt to drive growth.
What is the debt ratio of a bank? ›
A company's debt ratio can be calculated by dividing total debt by total assets. A debt ratio of greater than 1.0 or 100% means a company has more debt than assets while a debt ratio of less than 100% indicates that a company has more assets than debt.
Is 0.5 a good debt-to-equity ratio? ›
Is 0.5 a good debt-to-equity ratio? A 0.5 D/E ratio is good in the sense that the company has more equity than debt financing. This suggests lower risk for creditors and investors. However, it might also indicate the company is missing out on potential growth opportunities that debt financing can provide.
What is the debt-to-equity ratio for Wells Fargo? ›
Wells Fargo Debt to Equity Ratio: 1.089 for June 30, 2024
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What is an ideal debt-to-equity ratio is considered safe? ›
The ideal debt to equity ratio is 2:1. This means that at no given point of time should the debt be more than twice the equity because it becomes riskier to pay back and hence there is a fear of bankruptcy.
What is a good debt to asset ratio for a bank? ›
In general, a ratio around 0.3 to 0.6 is where many investors will feel comfortable, though a company's specific situation may yield different results.
What is a good debt-to-income ratio for banks? ›
As a general guideline, 43% is the highest DTI ratio a borrower can have and still get qualified for a mortgage. Ideally, lenders prefer a debt-to-income ratio lower than 36%, with no more than 28%–35% of that debt going toward servicing a mortgage.
What is the debt service ratio for banks? ›
The debt-service coverage ratio (DSCR) measures a firm's available cash flow to pay its current debt obligations. The DSCR shows investors and lenders whether a company has enough income to pay its debts. The ratio is calculated by dividing net operating income by debt service, including principal and interest.
Generally, a good debt-to-equity ratio is anything lower than 1.0. A ratio of 2.0 or higher is usually considered risky. If a debt-to-equity ratio is negative, it means that the company has more liabilities than assets—this company would be considered extremely risky.
Is a 1.0 debt-to-equity ratio good? ›
"Ratios over 2.0 are generally considered risky, whereas a ratio of 1.0 is considered safe." However, that's not foolproof when determining a company's financial health.
What should be the minimum debt-to-equity ratio? ›
An ideal debt-to-equity ratio typically falls between 1 and 1.5, indicating a balanced approach to financing through debt and equity. However, the ideal ratio can vary by industry. Capital-intensive industries like utilities may have higher ratios, while sectors like technology often have lower ratios.
What is a good debt to income ratio for banks? ›
As a general guideline, 43% is the highest DTI ratio a borrower can have and still get qualified for a mortgage. Ideally, lenders prefer a debt-to-income ratio lower than 36%, with no more than 28%–35% of that debt going toward servicing a mortgage.
What debt-to-equity ratio do lenders prefer? ›
The optimal D/E ratio varies by industry, but it should not be above a level of 2.0. A D/E ratio of 2 indicates the company derives two-thirds of its capital financing from debt and one-third from shareholder equity.
What is a good current ratio for a bank? ›
A healthy current ratio is between 1.2 and 2, indicating that the company has twice as many current assets as liabilities to cover its debts. A current ratio of less than one will indicate that the company lacks sufficient liquid assets to satisfy its short-term liabilities.
