By Sterling Xie. Edited by Arjun Chandrasekar.
Finance is certainly complicated, full of terms that seem to be mired in confusion. However, these terms ultimately can be simplified into simple phrases. The debt-to-equity ratio is one of these terms that is often misunderstood but is critical in the development of investment policies.
General Definitional Value
The debt-to-equity ratio is used to analyze a company’s financial capabilities and capital advantages. It is calculated by the quotient of total liabilities by shareholder equity. This term is generally used in times of financial crisis where businesses are collapsing in order to determine if the company can survive using shareholder equity to pay off debts. As such, a lower debt-to-equity (D/E) ratio is often less risky and is a better investment in terms of stability. However, a higher D/E ratio could be a more risky but profitable investment. When weighing these two options, it is often better to prefer the lower D/E ratios.
When using the debt-to-equity ratio to make investment decisions, it is important that it is hard to compare the debt-to-equity ratio across industries because the ideal amount of debt is often different as a result of different supply and demand situations and circumstances in different industries. For example, the utility industry often has an incredibly high D/E ratio because it is a necessary service and has a consistent income stream, meaning it is able to take on more debt.
Investors that use the D/E ratio to understand the market are often the more long-term investors because they prefer long-term concerns that are identified by the D/E ratio’s consideration of long-term debt. Day traders that are more concerned with short-term stability and profitability often use the cash ratio or current ratio that deals with current debt.
What classifies a good ratio?
A D/E ratio is good when it is 1.00 or under because it is relatively safe, seen as it means $1 of debt for every $1 of equity. However, a D/E ratio is bad when it is 2.00 or above as it is riskier.
D/E ratios are important in determining the viability of investments and are important in creating more stability within portfolios. However, specific limitations must be considered in order to create the most balanced portfolio.