The ratio is used to measure a company’s financial risk and is often used by lenders when assessing a company’s creditworthiness.
In essence, it measures how much debt and equity a company uses to finance its operations.
The D/E ratio is important because it can give you an idea of how risky a company is. A high D/E ratio means that the company is more likely to default on its debt payments.
A low D/E ratio indicates that the company is less risky and may be able to borrow money at lower interest rates.
You should care about the D/E ratio because it can help you determine if a company is in good financial health or not.
If you’re thinking about investing in a company, you’ll want to ensure that its D/E ratio is low enough not to be too risky.
What does debt-to-equity ratio mean?
An increased D/E ratio generally indicates that a business may have difficulty repaying its debts in a business downturn. A higher D/E ratio indicates a riskier business.
However, some industries, such as capital-intensive businesses that regularly invest in real estate, factories, and equipment, have a high D/E ratio. And from the other side, lifestyle, delivery, or service companies that do not require heavy machinery or large amounts of space will have a lower D/E.
While lenders and investors prefer that a business keep a low D/E ratio, a low D/E can also indicate that it is not correctly leveraging its assets, limiting its profitability.
The equity formula
The equity formula is used to calculate a company’s equity. The first step is to subtract liabilities from assets to determine total equity:
Equity = Assets – Liabilities
For example, if a business has $15,000 in assets and liabilities worth $5,000 each, then its total equity would be $10,000 ($15,000 – $5,000).
Your liabilities increase to $15,000 over time, while your assets remain at $10,000:
– $5,000 = $10,000 – $15,000
You have negative equity if your liabilities exceed your total assets. In this example, you have a $5,000 negative equity position.
The debt formula
The debt formula is the mathematical equation used to calculate a company’s total debts. The equation is:
Total Debt = Long Term Debt + Short Term Debt + Fixed Payments
Again, examine your liabilities using the balance sheet. Total business debt is calculated by adding all of your liabilities together.
For instance, if you have a $5,000 bank loan, $3000 in vendor accounts payable, and $1000 in fixed payments. Add all of your liabilities together to determine your total debt.
$9,000 = $5,000 + $3000 + $1000
You owe a total of $9,000.
The debt-to-equity ratio formula
The debt-to-equity ratio formula is:
Debt-to-Equity Ratio = Total Debt / Total Equity
You can calculate the debt-to-equity ratio using the examples above. For example, you have a total debt of $9,000 and total equity of $10,000.
0.9 = $9,000 / $10,000
The debt-to-equity ratio of your business is 0.9.
Consider what happens if you take out a $10,000 business loan to increase your total debt. Your total debt has risen to $19,000, and your equity has stayed at $10,000.
1.9 = $19,000 / $10,000
You now have a debt-to-equity ratio of 1.9.
You should care about the debt-to-equity ratio because it can tell you whether or not a company is in a risky situation.
If a company has more debt than equity, it may not be able to repay its obligations if it experiences financial difficulty.
You can use this information to decide whether or not to invest in that company.
How to interpret the debt-to-equity ratio
Your debt-to-equity ratio indicates how much debt you have for every dollar of equity. A debt-to-equity ratio of 0.5 means that you have $0.50 in debt for every dollar in equity.
A ratio greater than 1.0 indicates that there is more debt than equity. Thus, a debt-to-equity ratio of 1.5 means you have $1.50 in debt per each $1.00 in equity.
A high debt-to-equity ratio means that a company has more liabilities than equity, and it is seen as being at risk of not being able to repay its debts.
A low debt-to-equity ratio means that a company has more equity than liabilities and is less risky.
There are pros and cons to both high and low debt-to-equity ratios. A high D/E ratio can be harmful because it might mean the business isn’t using all of its available financing opportunities to grow, leading to stagnation or even bankruptcy if things go wrong.
However, a low D/E ratio can also be bad because it might mean the business isn’t taking on enough risks and could miss out on potential profits.
The important thing is that you understand your industry’s norms and what constitutes a good or bad debt-to-equity ratio for your specific business.
Negative debt-to-equity ratio
Occasionally, a business will have a negative ratio instead of a positive one. A negative debt-to-equity ratio indicates that the business’s shareholders’ equity is negative. If your liabilities exceed your assets, you have negative equity.
Lenders, stakeholders, and investors typically view a negative debt-to-equity ratio as risky. Once your ratio is negative, this may indicate that your business is on the verge of insolvency.
What can you use the debt-to-equity ratio for?
The debt-to-equity ratio is most commonly used when a company is considering issuing new equity or debt. The ratio can measure a company’s financial leverage and the riskiness of the company’s debt financing.
Here are some examples of what you can use it for:
Knowing how much shareholders earn
If you have shareholders, you must distribute a portion of your profits to them. When it comes time to distribute shareholder dividends, the shareholder earnings are calculated using the business’s profits.
However, if your debt-to-equity ratio is high, your profits may suffer. For shareholders, this may mean that their earnings are reduced due to the need to use profits to pay any interest or debt payments.
Investors and stakeholders are not the only parties considering a business’s risk. Lenders typically use the debt-to-equity ratio to determine your business’s ability to repay loans.
Your business’s creditworthiness demonstrates to lenders whether you can afford to pay back loans.
Additionally, lenders examine your credit history and installment payments to guarantee that you are actively repaying your debts.
When potential lenders or stakeholders evaluate your business, they look at your debt-to-equity ratio. Specifically, investors consider your ability to repay debt and how your business is reliant on debt.
Stakeholders examine all financial data in addition to your industry. If you work in a sector that completes work and bills clients after a project is completed, this information is critical. Why? You may be at a lower risk if your clients owe you money and you are anticipating payment.
However, if you work in an industry that requires upfront payment, your ratio may indicate a greater risk.