Does a higher debt equity ratio result in a higher degree of financial risk?
A higher debt to equity ratio indicates that more creditor financing (bank loans) is used than investor financing (shareholders). Higher use of debt increases the fixed financial charges (Interest on Debt) of a firm. As a result, increased used of debt increases the financial risk of a firm.
The debt-to-equity (D/E) ratio is a metric that provides insight into a company's use of debt. In general, a company with a high D/E ratio is considered a higher risk to lenders and investors because it suggests that the company is financing a significant amount of its potential growth through borrowing.
The debt-to-equity ratio often is associated with risk: A higher ratio suggests higher risk and that the company is financing its growth with debt. However, when a company is in its growth phase, a high D/E ratio might be necessary for that growth.
If the debt-to-equity ratio is too high, there will be a sudden increase in the borrowing cost and the cost of equity. Also, the company's weighted average cost of capital WACC will get too high, driving down its share price.
A higher debt-to-equity ratio often signifies that a company poses a higher risk to its shareholders, increasing the possibility of bankruptcy if profits slow. Essentially, it means the company has heavily relied on debt for its growth.
Companies that invest large amounts of money in assets and operations (capital-intensive companies) often have a higher debt ratio. For lenders and investors, a high ratio means a riskier investment because the business might not be able to make enough money to repay its debts.
A high debt to equity ratio indicates a business using debt to finance its growth. Companies that invest large amounts of money in assets and operations (capital-intensive companies) often have a higher debt ratio.
The debt-to-equity ratio (D/E ratio) shows how much debt a company has compared to its assets. It is found by dividing a company's total debt by total shareholder equity. A higher D/E ratio means the company may have a harder time covering its liabilities.
Debt-to-Equity Ratio
Companies with stronger equity positions are typically better equipped to weather temporary downturns in revenue or unexpected needs for additional capital investment. Higher D/E ratios may negatively impact a company's ability to secure additional financing when needed.
Generally, a lower ratio is better, as it implies that the company is in less debt and is less risky for lenders and investors. A debt-to-equity ratio of 0.5 or below is considered good.
Is 0.9 a good debt-to-equity ratio?
Debt-to-equity ratio values tend to land between 0.1 (almost no debt relative to equity) and 0.9 (very high levels of debt relative to equity). Most companies aim for a ratio between these two extremes, both for reasons of economic sustainability and to attract investors or lenders.
However, the biggest risk in this scenario is the inability to pay off debts. If an individual is unable to make their debt payments, they may face serious consequences such as damage to their credit score, collection efforts, or even legal action.
Generally, companies prefer a debt-to-equity ratio that's lower than two. A low figure shows the company has good financial standing. Financial experts generally consider a debt-to-equity ratio of one or lower to be superb.
A good debt to equity ratio is around 1 to 1.5. However, the ideal debt to equity ratio will vary depending on the industry because some industries use more debt financing than others. Capital-intensive industries like the financial and manufacturing industries often have higher ratios that can be greater than 2.
A D/E 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.
High debt-to-equity ratios raise red flags for investors. The perception may be that the company is not performing well and is too risky an investment since more creditors finance operations than investors.
Higher rates of interest imply a greater chance of default and, therefore, carry a higher level of risk. Higher interest rates help to compensate the borrower for the increased risk. In addition to paying interest, debt financing often requires the borrower to adhere to certain rules regarding financial performance.
As a general rule of thumb, it's best to have a debt-to-income ratio of no more than 43% — typically, though, a “good” DTI ratio is below 35%.
| 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 |
It indicates what proportion of equity and debt the company is using to finance its assets. A high debt/equity ratio generally means that a company has been aggressive in financing its growth with debt.
What is a bad debt ratio?
The bad debt to sales ratio represents the fraction of uncollectible accounts receivables in a year compared to total sales. For example, if a company's revenue is $100,000 and it's unable to collect $3,000, the bad debt to sales ratio is (3,000/100,000=0.03).
The debt/equity ratio can be defined as a measure of a company's financial leverage calculated by dividing its long-term debt by stockholders' equity. Amazon debt/equity for the three months ending December 31, 2023 was 0.29.
From a pure risk perspective, debt ratios of 0.4 or lower are considered better, while a debt ratio of 0.6 or higher makes it more difficult to borrow money. While a low debt ratio suggests greater creditworthiness, there is also risk associated with a company carrying too little debt.
Still, as a general rule of thumb, most companies aim for an equity ratio of around 50%. Companies with ratios ranging around 50% to 80% tend to be considered “conservative”, while those with ratios between 20% and 40% are considered “leveraged”.
Risk assessment and identification involves searching for anything that threatens financial stability. The threat can be internal, such as operational inefficiencies, or external, such as market volatility. Historical data analysis, industry research, and brainstorming sessions can be useful in identifying risk.
