What Debt-to-Equity Ratio Is Common for a Bank?

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 debt-to-equity ratio means that more of a company’s financing is from debt versus issuing shares of equity. Banks commonly have slightly elevated D/E ratios because they operate with higher financial leverage. We explore what this means in a little more detail below.

Calculating the D/E Ratio

The D/E ratio is considered a key financial metric because it indicates potential financial risk. It is calculated as follows:

D/E Ratio = Total Liabilities ÷ Total Shareholders’ Equity

For example, if 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 ($60 million ÷ $130 million). 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 when it comes to the company’s assets.

The D/E Ratio and Risk

A relatively high D/E ratio commonly indicates an aggressive growth strategy because it has taken on debt. For investors, this means potentially increased profits with a correspondingly increased risk of loss. If the extra debt enables the company to increase net profits by an amount greater than the interest cost, then the company should deliver a higher return on equity (ROE) to investors.

Keep in mind that a company with a high D/E ratio and a high ROE is considered more risky and less desirable than a company achieving the same ROE with less debt.

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 D/E Level Is Considered Desirable?

A high D/E ratio is not always detrimental to a company’s profits. If the company can demonstrate sufficient cash flow to service its debt obligations and the leverage increases equity returns, that can be a sign of financial strength.

However, not all high D/E and high ROE companies are so successful. 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 ROE is higher. The inflation of the ROE metric by high debt can hide problems within a company. A high ROE alone doesn’t make a company a good investment, which means investors should examine other metrics to determine the company’s health.

The cost of debt is typically lower than the cost of equity. Therefore, another advantage of 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.

A D/E ratio of 1.5 or lower is considered desirable for most companies while a ratio higher than 2 is considered less favorable. That’s because a higher ratio means a company is financing more of its operations with debt. D/E ratios vary significantly between industries, so investors should compare the ratios of similar companies in the same industry.

In the banking industry, a relatively high D/E ratio is acceptable in some situations because the core of the business revolves around borrowing and lending. Although risky, financial leverage is also tied to banking profits—lending money at a higher rate means earning more than the cost of borrowing. Banks with a lot of fixed assets, such as those with a large branch network, also tend to carry slightly elevated amounts of debt in a healthy way.

The Bottom Line

A bank’s D/E ratio measures its financial leverage, comparing its liabilities to its shareholders’ equity. In most cases, a ratio of 1.5 or lower is desirable while a higher ratio can be problematic because it means a company is financing more of its operations with debt. Banks, though, can operate with a higher ratio