14/12/2019 What Debt-to-Equity Ratio Is Common for a Bank?

CORPORATE FINANCE & ACCOUNTING FINANCIAL RATIOS

What Debt-to-Equity Ratio Is Common for a

Bank?

BY J.B. MAVERICK | Updated Jun 26, 2019

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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Calculating the D/E Ratio

The D/E ratio is calculated as total liabilities divided by total shareholders' equity. For
example, if, as per the balance sheet, the total debt of a business is worth $60 million and the
total equity is worth $130 million, then the debt-to-equity is 0.46. In other words, for every
dollar in equity, the firm has 46 cents in leverage. A ratio of 1 indicates that creditors and
investors are balanced with respect to the company’s assets. The D/E ratio is considered a
key financial metric because it indicates potential financial risk.

The D/E Ratio and Risk

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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.

What Is Considered A High Debt-To-Equity Ratio?

What Level of Debt-to-Equity Is Considered Desirable?

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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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Debt-To-Equity Ratio – D/E Definition

The debt-to-equity (D/E) ratio indicates how much debt a company is using to finance its assets
relative to the value of shareholders’ equity. more

How the Leverage Ratio Works

A leverage ratio is any one of several financial measurements that look at how much capital comes in
the form of debt, or that assesses the ability of a company to meet financial obligations. more

Equity Multiplier Definition

Equity Multiplier is a financial leverage ratio that measures the portion of company’s assets that are
financed by stockholder's equity. more

How to Calculate the Weighted Average Cost of Capital – WACC

The weighted average cost of capital (WACC) is a calculation of a firm's cost of capital in which each
category of capital is proportionately weighted. All sources of capital, including common stock,
preferred stock, bonds, and any other long-term debt, are included in a WACC calculation. more

How to Use the DuPont Analysis to Assess a Company's ROE

The DuPont analysis is a framework for analyzing fundamental performance popularized by the
DuPont Corporation. DuPont analysis is a useful technique used to decompose the different drivers of
return on equity (ROE). more

What the Total Debt-to-Capitalization Ratio Tells Us

The total debt-to-capitalization ratio is a tool that measures the total amount of outstanding company
debt as a percentage of the firm’s total capitalization. The ratio is an indicator of the company's
leverage, which is debt used to purchase assets. more

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