The average debt-to-equity ratio for retail and commercial U.S. banks, as of January 2015, is approximately 2.2. For investment banks, the average debt/equity is higher, about 3.1.
The debt/equity ratio is a leverage ratio that represents what amount of debt and equity is being used to finance a company’s assets. It is calculated as total liabilities divided by total shareholders’ equity. The debt/equity ratio is considered a key financial metric because it indicates potential financial risk.
A relatively high debt/equity ratio commonly indicates an aggressive growth strategy by a company. For investors, this means potential 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 to investors. However, if the interest cost of the extra debt does not lead to a significant increase in revenues, the additional debt burden reduces the company’s profitability. In a worst-case scenario, it could overwhelm the company financially, resulting in insolvency and eventual bankruptcy.
Typically, a debt/equity ratio of 1.5 or lower is considered good, and ratios higher than 2 are considered less favorable, but average debt/equity ratios vary significantly between industries. Therefore, when examining a company’s debt/equity situation, investors should compare it with that of similar companies in the same industry. A relatively high debt/equity ratio is commonplace in the banking industry and in the financial services sector as a whole. Banks carry greater debt amounts because the money they borrow is also the money they lend. To put it another way, the major product that banks sell is debt. Therefore, it is logical that they have more of that product on hand than is common in other industries.