The debt-to-equity ratio is an important financial metric for investors because it signifies potential risk. A high debt-to-equity ratio is normal for some industries. The financial sector leads all industries when comparing debt-to-equity ratios. That ratio, however, may be misleading for banks and other financial institutions because they typically borrow money to lend money, which is why banks are highly regulated.
By and large, the financial sector stands out when comparing debt-to-equity ratios. Certain industries, however -- especially those that are highly capital intensive, such as the industrial goods sector -- utilize debt as common practice. Among them are aerospace and defense, as well as those that include manufacturers of general building materials and farm and construction machinery. As of 2018, the aerospace industry has a debt-to-equity ratio of 16.97 and the construction materials sector average is 30.90.
The finance sector's average debt-to-equity ratio on the day before the date of publication was an eye-popping 1030.23. A huge disparity between debt and equity for financial companies compared to other industries is not a cause for concern. Remember, a financial company such as a bank borrows money at a lower rate and lends the money at a higher rate, making a profit on the spread between the two. Therefore, simply using debt to equity as a measurement of financial risk for a bank or other financial institution is misleading.
Any financial institution -- particularly a bank -- that is not adequately capitalized can cause trouble for the economy as a whole. That is why banks, insurance companies and other commercial lenders face stiff regulations. Some of the terms you'll hear when discussion turns to the soundness of a financial institution are "Tier 1 capital," "Tier 2 capital" and "reserves." These are the metrics that regulators and investors use to evaluate banks rather than simply focusing on debt-to-equity ratios. In essence, a bank must maintain certain minimum capital requirements and reserves as a cushion against loan losses.
A high debt-to-equity ratio -- no matter the industry -- places a company in a precarious position. Several missed interest payments could spell financial ruin for the company, which is why investors focus on the ratio. It is a good practice to compare companies within an industry to spot a company with an above-average debt-to-equity ratio. That ratio, however, tells only part of the story. It's not uncommon for a company to issue bonds rather than sell additional shares because of the lower cost of debt, as interest payments are tax deductible. Issuing additional shares also dilutes the fractional ownership of shareholders. What matters is whether the company invests the proceeds from its borrowing into projects that generate a return above its cost of capital.
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