In nutrition science, there's a theory of metabolic typing that determines what type of macronutrient – protein, fat, carbs or a mix – you run best on. The debt-to-equity ratio is the metabolic typing equivalent for businesses. It can tell you what type of funding – debt or equity – a business primarily runs on.
"Observing a company's capital structure is very important as the cost of capital has increased significantly in the aftermath of the Federal Reserve's steep rate hikes," says Stash Graham, managing director at Graham Capital Wealth Management. "As debt becomes more expensive to service, companies with larger than average debt burdens must allocate more cash towards paying down debt instead of returning that cash to shareholders through cash dividends or share repurchases."
Here's what you need to know about the debt-to-equity ratio and what it reveals about a company's capital structure to make better investing decisions.
What is the debt-to-equity ratio?
The debt-to-equity ratio is a financial ratio that measures how much debt a company has relative to its shareholders' equity. It can signal to investors whether the company leans more heavily on debt or equity financing. A company with a high debt-to-equity ratio uses more debt to fund its operations than a company with a lower debt-to-equity ratio.
The debt-to-equity ratio also gives you an idea of how solvent a company is, says Joe Fiorica, head of Global Equity Strategy at Citi Global Wealth. "Solvency refers to a firm's ability to meet financial obligations over the medium-to-long term."
Why is the debt-to-equity ratio important?
If you're an equity investor, you should care deeply about a firm's ability to make debt obligations, because common stockholders are the last to receive payment in the event of a company liquidation.
"Once bond principal and interest payments are made, the leftover profits are retained by shareholders and can be paid out in the form of dividends or buybacks," Fiorica says. "Therefore, a lower debt-to-equity ratio implies that equity holders have a greater chance of benefiting from growth in retained earnings over time and a lower risk of default."
How to calculate the debt-to-equity ratio
You can calculate the debt-to-equity ratio by dividing shareholders' equity by total debt. For example, if a company's total debt is $20 million and its shareholders' equity is $100 million, then the debt-to-equity ratio is 0.2. This means that for every dollar of equity, the company has 20 cents of debt, or leverage.
While using total debt in the numerator of the debt-to-equity ratio is common, a more revealing method would use net debt, or total debt minus cash in cash and cash equivalents the company holds.
The thought is this company can use that cash immediately to pay down debt if wanted," Graham says. "As such, an investor should give the company credit for any money at hand that it has on its balance sheet and subtract that from total debt."
You could also replace the book equity found on the balance sheet with the market value of the company's equity, called enterprise value, in the denominator, he says. "The book value is beholden to many accounting principles that might not reflect the company’s actual value."
What is a good debt-to-equity ratio?
"A good debt-to-equity ratio depends on the type of business," Graham says. Does the company generate consistent operating cash flow? Is the company cyclical or non-cyclical in structure?
"Ideally, you want companies to have more equity than debt," he says.
A good debt-to-equity ratio also varies by industry. For example, utilities tend to be a highly indebted industry whereas energy was the lowest in the first quarter of 2024.
These ratios can fluctuate over time even within industries. The energy industry, for example, only recently shifted to a lower debt structure, Graham says.
"In the last six years, you have seen this industry navigate two rounds of bankruptcy waves where companies in the energy sector had to navigate highly leveraged balance sheets with meager energy prices," he says. "Today, we are witnessing energy companies with strong balance sheets. Management teams have learned the lessons of prior years and have retired a lot of outstanding debt."
When debt-to-equity ratios vary greatly within an industry, it can be a "feast for stock pickers who can seek out companies with lower levels of debt while avoiding the over-levered firms that sit in passive indices," Fiorica says.
Final notes on debt-to-equity ratios
"In the world of stock and bond investing, there is no single metric that tells the entire story of a potential investment," Fiorica says. "While debt-to-equity ratios are a useful summary of a firm's use of financial leverage, it is not the only signal for equity analysts to focus on."
In fact, a firm that uses its leverage to capitalize on a high-return project will likely outperform one that uses very little debt but sits in an unfavorable position in its industry, he says.
At Citi, they "consider not only leverage, but prospective earnings growth, valuation, dividend payouts and liquidity position as well as qualitative factors like management quality and business position," Fiorica says. You would be wise to do the same with your prospective investments.
