The optimal debt to equity (D/E) ratio varies widely by industry, but the general consensus is that it should not be above 2. While some very large companies in fixed asset-heavy industries may have ratios higher than 2, these are the exception rather than the rule. A D/E ratio of 2 indicates that the company derives two-thirds of its capital financing from debt and one-third from shareholder equity, so it borrows twice as much funding as it owns.
The D/E ratio is a financial leverage ratio that compares a company's total liabilities to its shareholder equity. It is widely considered one of the most important corporate valuation metrics, because it highlights a company's dependence on borrowed funds and its ability to meet those financial obligations. Because debt is inherently risky, lenders and investors tend to favor businesses with lower D/E ratios. For lenders, a low ratio means a lower risk of loan default. For shareholders, it means a decreased probability of bankruptcy in the event of an economic downturn. A company with a higher ratio than its industry average, therefore, may have difficulty securing additional funding from either source.
However, a business that ignores debt financing entirely may be neglecting important growth opportunities. The benefit of debt capital is that it allows businesses to leverage a small amount of money into a much larger sum and repay it over time. This allows businesses to fund expansion projects more quickly than might otherwise be possible, theoretically increasing profits at an increased rate. A company that does not make use of the leveraging potential of debt financing may be doing a disservice to the ownership and shareholders by limiting the ability of the company to generate maximum profits.
When looking at a company's balance sheet, it is important to consider the average D/E ratios for the given industry, as well as those of the company's closest competitors. There are many metrics used in corporate accounting as indicators of financial health that should be studied alongside the D/E ratio.