In the utilities sector, for companies providing general utilities such as gas and electricity, the average debt/equity ratio, or D/E ratio, is approximately 1.3. For companies primarily engaged in providing water and sewage service, the average ratio is slightly lower, approximately 1.2.
Utilities carry high debt levels as their infrastructure requirements make large, periodic capital expenditures necessary. However, they also have a large amount of investment equity because they are such “bedrock” stocks; they are included in the investment portfolio of many funds and individual investors.
The Utilities Sector
The utilities sector encompasses all companies whose core business involves producing, generating or distributing the basic utilities: gas, electricity and water.
Since utilities typically carry high debt levels, they are subject to interest rate risk, and their D/E ratio is an important metric for evaluating their overall financial health. The stocks of utilities sector companies generally tend to perform best when interest rates fall or are low.
The Debt/Equity Ratio
The D/E ratio is a metric used to determine the degree of a company’s financial leverage. The formula to calculate this ratio divides a company’s total liabilities by the amount of equity provided by stockholders. This metric reveals the respective amounts of debt and equity a company utilizes to finance its operations.
When a company’s D/E ratio is high, it suggests the company has taken an aggressive growth financing approach with its debt. One issue with this approach is additional interest expenses can often cause volatility in earnings reports. If earnings generated are greater than the cost of interest, shareholders benefit. However, if the cost of debt financing outweighs the return generated by the additional capital, the financial load could be too heavy for the company to bear.
Evaluating a company using the D/E ratio is dependent on the company’s industry. Capital-intensive industries such as utilities have relatively higher D/E ratios. Therefore, D/E ratios should be considered in comparison to similar companies within the same industry. Generally, ratios 0.5 and below are considered excellent, while ratios above 2.0 are viewed unfavorably.