What Is Debt-to-Equity Ratio and Why Is It Important?
A debt-to-equity ratio shows how a company chooses to finance its operations. They can do so either through net worth (assets, equity, wholly owned capital) or by taking on liabilities and creating debt through loans. Debt-to-equity ratios are calculated by dividing the company’s total liabilities and debts by its shareholder equity.
Debt-to-equity ratios are important to consider for businesses working to expand. Banks use these ratios to consider each applicant’s ability to pay back debts like a loan or line of credit. If a company has a high debt-to-equity ratio, shareholders and lenders may be wary of purchasing stock or offering a loan, respectively. A high debt-to-equity ratio means that the company is leveraged, or owes more in debt than it owns in assets and/or equity or net worth.
A debt–to–income percentage is used more often to define an individual financial portfolio, and it’s calculated by dividing monthly debt payments by monthly gross income. This percentage will indicate a borrower’s ability to pay back a loan and how well monthly expenses can be managed.
To measure the creditworthiness of a company, there are a number gearing or leverage ratios that can be taken into account:
- Debt-to-equity ratio;
- Shareholders equity ratio;
- Debt-service coverage ratio.
The accumulation of data from all of these ratios will determine a company’s solvency, or ability to pay off all debt by selling assets.
The debt-to-equity ratio is used to calculate a ratio that exemplifies the liability of the shareholder to the lender.
- Debt-to-equity ratio = Total liabilities / Total equity.
The total equity in this formula consists of the company’s net worth, or its assets minus its liabilities. This is also known as the shareholder’s equity, and the terms may be used interchangeably in this context.
These calculations create insight into the financial decisions of the company and show the capital structure (the amount of fully-owned funds, equity, or debt) as well as how they fund expansion and purchases (through debt, fully owned funding, or equity financing).
For example, company A has $100,000 in total equity and assets but is in debt $20,000 to the lender. They are a slow-growing company with a steady profit in a specific and monopolized market.
Their current debt-to-equity ratio would be as follows:
- 1:2, 20%, or 0.20 debt-to-equity ratio = $20,000 / $100,000.
For every dollar in equity, 20 cents is debt.
Company A wishes to purchase another warehouse to continue building their product, this will cost an additional $60,000. If the lender were to accept the loan, this would change the debt-to-equity ratio:
- 1:8, 80%, or 0.80 Debt-to-Equity ratio = ($20,000 + $60,000 = $80,000) / $100,000.
For every dollar in equity, 80 cents is debt.
Of the many factors involved such as a low potential for a changing economy or market place, or the lack of intensity of competition, the bank may consider that though the leverage is high, the risks are low. If something drastic occurred, Company A would be solvent, the assets of the company could be sold to pay off any remaining debt.
Another example, company B has $100,000 in total equity and assets, but is in debt $20,000 to the lender. They are a fast-growing company with a high profit in a niche market that is subject to intense competition and a quickly changing marketplace.
The current debt-to-equity ratio would be as follows:
- 20%, or 0.20 Debt-to-Equity ratio = $20,000 / $100,000.
For every dollar in equity, 20 cents is debt.
Company B wishes to take out a loan for an additional $100,000 to build a new warehouse and double their production and profit. If the lender were to accept the loan, this would change the debt-to-equity ratio.
- 1:1.2, 120%, or 1.2 = (20,000+ 100,000 = $120,000) / $100,000.
For every dollar in equity, $1.20 is debt.
Considering the factors involved — a competitive niche and a quickly changing marketplace — the bank may consider that even with high profits, the high leverage and insolvency would be too much of a risk. If something drastic happened, the sale of the total assets would not cover the debt.
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What Is a Good Debt-to-Equity Ratio?
Unfortunately, there is no concrete answer. Experts say that the ideal debt-to-equity ratio is completely dependent upon the industry. Most industries ideal ratios tend towards 2 or below, while some large manufacturers or publicly traded companies may have ratios between 2 and 5 — and even still, there are industry-specific exceptions. Therefore, a good debt-to-equity ratio is variable to the company, it’s peers, and the market it participates in.
While a high debt-to-equity ratio may make a company seem like a risk, a lower one makes a company seem more stable, as it is spending less on debt than receiving equity. There are benefits and drawbacks to both.
Using debt to finance an increase in production/company size may increase the company’s leverage, but it also has a lower cost of capital and interest compared to equity financing. Interest rates on business loans are also deductible on company tax returns.
Using equity or shareholder equity saves the risk of leverage and high debt but also may become costly or inefficient; perhaps the percentage rate of investors is much higher than the interest on a loan. Or it may result in a leveraged buyout, where controlling shares of the company are purchased with outside capital.
The best way to look at a good debt-to-equity ratio is to assess the industry and strive to strike a balance.
The debt-to-equity formula:
- Debt-to-equity ratio = total liabilities and debt / total equity;
The debt-to-equity formula in a long and more in-depth formula:
- Debt-to-equity ratio = (short-term debt + long-term debt + fixed payment obligations) / total equity.
The longer formula splits and categorizes debt so that it can be further evaluated by the business as well as the lender. Categorizing debts into short/current liabilities and long-term liabilities reveals the roadmap of debts and finances for the future of the company. Short-term debts are often considered less risky because they will be paid in a year or less, while long-term debts are more sensitive to shifting interest rates over a period of time.
Short-term debt, or current liabilities, are financial obligations that are expected to be paid off within a year. This may include but is not limited to:
- Accounts payable;
- Income taxes payable;
- Lease payments;
- Deferred revenues;
- Dividends payable.
Long-term debt is considered financing debt that has a maturity longer than one year.
This may include but is not limited to:
- Financing, loans, or capital lease obligations;
- Lines of credit;
- Fixed liabilities;
- Bond issues that have been capitalized.
Debt-to-Equity Ratio Calculator
This quick and easy-to-use calculator will provide a debt-to-equity ratio utilizing the short formula consisting of the shareholder equity. To further break down the shareholder equity, short- and long-term debt, and fixed payment obligations, you may need to consult the company balance sheet.
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