Which one of the following ratios would be of greatest interest to the common shareholders

The debt-to-equity (D/E) ratio is used to evaluate a company's financial leverage and is calculated by dividing a company’s total liabilities by its shareholder equity. The D/E ratio is an important metric used in corporate finance. It is a measure of the degree to which a company is financing its operations through debt versus wholly owned funds. More specifically, it reflects the ability of shareholder equity to cover all outstanding debts in the event of a business downturn. The debt-to-equity ratio is a particular type of gearing ratio.

The debt-to-equity (D/E) ratio compares a company’s total liabilities to its shareholder equity and can be used to evaluate how much leverage a company is using.
Higher-leverage ratios tend to indicate a company or stock with higher risk to shareholders.
However, the D/E ratio is difficult to compare across industry groups where ideal amounts of debt will vary.
Investors will often modify the D/E ratio to focus on long-term debt only because the risks associated with long-term liabilities are different than short-term debt and payables.

$\begin{aligned} &\text{Debt/Equity} = \frac{ \text{Total Liabilities} }{ \text{Total Shareholders' Equity} } \\ \end{aligned}$

The information needed for the D/E ratio is on a company's balance sheet. The balance sheet requires total shareholder equity to equal assets minus liabilities, which is a rearranged version of the balance sheet equation:

$\begin{aligned} &\text{Assets} = \text{Liabilities} + \text{Shareholder Equity} \\ \end{aligned}$

These balance sheet categories may contain individual accounts that would not normally be considered “debt” or “equity” in the traditional sense of a loan or the book value of an asset. Because the ratio can be distorted by retained earnings/losses, intangible assets, and pension plan adjustments, further research is usually needed to understand a company’s true leverage.

Because of the ambiguity of some of the accounts in the primary balance sheet categories, analysts and investors will often modify the D/E ratio to be more useful and easier to compare between different stocks. Analysis of the D/E ratio can also be improved by including short-term leverage ratios, profit performance, and growth expectations.

Melissa Ling {Copyright} Investopedia, 2019.

Business owners use a variety of software to track D/E ratios and other financial metrics. Microsoft Excel provides a balance sheet template that automatically calculates financial ratios such as the D/E ratio and debt ratio. However, even the amateur trader may want to calculate a company's D/E ratio when evaluating a potential investment opportunity, and it can be calculated without the aid of templates.

Given that the D/E ratio measures a company’s debt relative to the value of its net assets, it is most often used to gauge the extent to which a company is taking on debt as a means of leveraging its assets. A high D/E ratio is often associated with high risk; it means that a company has been aggressive in financing its growth with debt.

If a lot of debt is used to finance growth, a company could potentially generate more earnings than it would have without that financing. If leverage increases earnings by a greater amount than the debt’s cost (interest), then shareholders should expect to benefit. However, if the cost of debt financing outweighs the increased income generated, share values may decline. The cost of debt can vary with market conditions. Thus, unprofitable borrowing may not be apparent at first.

Changes in long-term debt and assets tend to have the greatest impact on the D/E ratio because they tend to be larger accounts compared to short-term debt and short-term assets. If investors want to evaluate a company’s short-term leverage and its ability to meet debt obligations that must be paid over a year or less, they can use other ratios.

For example, an investor who needs to compare a company’s short-term liquidity or solvency will use the cash ratio:

$\begin{aligned} &\text{Cash Ratio} = \frac{ \text{Cash} + \text{Marketable Securities} }{ \text{Short-Term Liabilities } } \\ \end{aligned}$

or the current ratio:

$\begin{aligned} &\text{Current Ratio} = \frac{ \text{Short-Term Assets} }{ \text{Short-Term Liabilities } } \\ \end{aligned}$

instead of a long-term measure of leverage such as the D/E ratio.

The shareholders' equity portion of the balance sheet is equal to the total value of assets minus liabilities, but that isn’t the same thing as assets minus the debt associated with those assets. A common approach to resolving this issue is to modify the D/E ratio into the long-term D/E ratio. An approach like this helps an analyst focus on important risks.

Short-term debt is still part of the overall leverage of a company, but because these liabilities will be paid in a year or less, they aren’t as risky. For example, imagine a company with $1 million in short-term payables (wages, accounts payable, and notes, etc.) and $500,000 in long-term debt, compared to a company with $500,000 in short-term payables and $1 million in long-term debt. If both companies have $1.5 million in shareholder equity, then they both have a D/E ratio of 1.00. On the surface, the risk from leverage is identical, but in reality, the second company is riskier.

As a rule, short-term debt tends to be cheaper than long-term debt, and it is less sensitive to shifting interest rates, meaning the second company’s interest expense and cost of capital are higher. If interest rates fall, long-term debt will need to be refinanced, which can further increase costs. Rising interest rates would seem to favor the company with more long-term debt, but if the debt can be redeemed by bondholders it could still be a disadvantage.

The D/E ratio can apply to personal financial statements as well, in which case it is also known as the personal D/E ratio. Here, “equity” refers to the difference between the total value of an individual’s assets and the total value of their debt or liabilities. The formula for the personal D/E ratio is represented as:

$\begin{aligned} &\text{Debt/Equity} = \frac{ \text{Total Personal Liabilities} }{ \text{Personal Assets} - \text{Liabilities} } \\ \end{aligned}$

The personal D/E ratio is often used when an individual or small business is applying for a loan. Lenders use the D/E to evaluate how likely it would be that the borrower is able to continue making loan payments if their income was temporarily disrupted.

For example, a prospective mortgage borrower who is out of a job for a few months is more likely to be able to continue making payments if they have more assets than debt. This is also true for an individual applying for a small business loan or line of credit. If the business owner has a good personal D/E ratio, it is more likely that they can continue making loan payments while their business is growing.

Gearing ratios constitute a broad category of financial ratios, of which the D/E ratio is the best example. "Gearing" simply refers to financial leverage.

Gearing ratios focus more heavily on the concept of leverage than other ratios used in accounting or investment analysis. This conceptual focus prevents gearing ratios from being precisely calculated or interpreted with uniformity. The underlying principle generally assumes that some leverage is good, but too much places an organization at risk.

At a fundamental level, gearing is sometimes differentiated from leverage. Leverage refers to the amount of debt incurred for the purpose of investing and obtaining a higher return, while gearing refers to debt along with total equity—or an expression of the percentage of company funding through borrowing. This difference is embodied in the difference between the debt ratio and the D/E ratio.

The real use of debt/equity is comparing the ratio for firms in the same industry—if a company's ratio varies significantly from its competitors' ratios, that could raise a red flag.

When using the D/E ratio, it is very important to consider the industry in which the company operates. Because different industries have different capital needs and growth rates, a relatively high D/E ratio may be common in one industry, while a relatively low D/E may be common in another.

Utility stocks often have a very high D/E ratio compared to market averages. A utility grows slowly but is usually able to maintain a steady income stream, which allows these companies to borrow very cheaply. High-leverage ratios in slow-growth industries with stable income represent an efficient use of capital. The consumer staples or consumer non-cyclical sector tends to also have a high D/E ratio because these companies can borrow cheaply and have a relatively stable income.

Analysts are not always consistent about what is defined as debt. For example, preferred stock is sometimes considered equity, but the preferred dividend, par value, and liquidation rights make this kind of equity look a lot more like debt.

Including preferred stock in total debt will increase the D/E ratio and make a company look riskier. Including preferred stock in the equity portion of the D/E ratio will increase the denominator and lower the ratio. It can be a big issue for companies such as real estate investment trusts (REITs) when preferred stock is included in the D/E ratio.

At the end of 2017, Apache Corporation (APA) had total liabilities of $13.1 billion, total shareholder equity of $8.79 billion, and a D/E ratio of 1.49. ConocoPhillips (COP) had total liabilities of $42.56 billion, total shareholder equity of $30.8 billion, and a D/E ratio of 1.38 at the end of 2017:

$\begin{aligned} &\text{APA} = \frac{ \$13.1 }{ \$8.79 } = 1.49 \\ \end{aligned}$

$\begin{aligned} &\text{COP} = \frac{ \$42.56 }{ \$30.80 } = 1.38 \\ \end{aligned}$

On the surface, it appears that APA’s higher-leverage ratio indicates higher risk. However, this may be too generalized to be helpful at this stage, and further investigation would be needed.

We can also see how reclassifying preferred equity can change the D/E ratio in the following example, in which it is assumed that a company has $500,000 in preferred stock, $1 million in total debt (excluding preferred stock), and $1.2 million in total shareholder equity (excluding preferred stock).

The D/E ratio with preferred stock as part of total liabilities would be as follows:

D/E = ($1 million + $500,000) / $1.2 million = 1.25

The D/E ratio with preferred stock as part of shareholder equity would be:

D/E = $1 million / ($1.25 million + $500,000) = 0.57

Other financial accounts, such as unearned income, will be classified as debt and can distort the D/E ratio. Imagine a company with a prepaid contract to construct a building for $1 million. The work is not complete, so the $1 million is considered a liability. If this amount is included in the D/E calculation, the numerator will be increased by $1 million.

What counts as a “good” debt-to-equity (D/E) ratio will depend on the nature of the business and its industry. Generally speaking, a D/E ratio below 1.0 would be seen as relatively safe, whereas ratios of 2.0 or higher would be considered risky.

Some industries, such as banking, are known for having much higher D/E ratios than others. Note that a D/E ratio that is too low may actually be a negative signal, indicating that the firm is not taking advantage of debt financing to expand and grow.

A debt-to-equity ratio of 1.5 would indicate that the company in question has $1.50 of debt for every $1 of equity. To illustrate, suppose the company had assets of $2 million and liabilities of $1.2 million. Because equity is equal to assets minus liabilities, the company’s equity would be $800,000. Its D/E ratio would therefore be $1.2 million divided by $800,000, or 1.5.

If a company has a negative D/E ratio, this means that the company has negative shareholder equity. In other words, it means that the company has more liabilities than assets. In most cases, this is considered a very risky sign, indicating that the company may be at risk of bankruptcy. For instance, if the company in our earlier example had liabilities of $2.5 million, its D/E ratio would be -5.

In the banking and financial services sector, a relatively high D/E ratio is commonplace. Banks carry higher amounts of debt because they own substantial fixed assets in the form of branch networks. Other industries that commonly show a relatively higher ratio are capital-intensive industries, such as the airline industry or large manufacturing companies, which utilize a high level of debt financing as a common practice.

A higher D/E ratio may make it harder for a company to obtain financing in the future. This means that the firm may have a harder time servicing its existing debts. Very high D/Es can be indicative of a credit crisis in the future, including defaulting on loans or bonds, or even bankruptcy.