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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 tend to have higher D/E ratios
because they borrow capital in order to lend to customers. They also have substantial fixed
assets, i.e., local branches, for example.
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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, 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.
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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. In this case,
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.
FAST FACT
Bank of America's D/E ratio for the three months ending March
31, 2019, was 0.96. In March 2009, during the financial crisis, the
ratio reached 2.65, according to Macrotrends.
Typically, the cost of debt is lower than the cost 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 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.
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