For businesses to be financially successful, they often have to take on debt. This debt helps companies fund projects, upgrade existing technology, purchase equipment, and acquire inventory among other things that can contribute to a company’s growth.
Debt is necessary for most companies, but not all can get approved for loans due to their debt-to-equity ratio. If you’re asking what that means, you’re not alone. The term can be a bit confusing to understand, but this guide is here to help.
What Is the Debt-to-Equity Ratio?
The debt-to-equity — or D/E — ratio tells a company how much debt it has compared to its shareholders’ equity. This measure helps company leaders and interested parties determine the business’s financial health.
Why Measuring Debt to Equity Is Important?
Measuring debt to equity is not typically done in everyday accounting. It is a tool primarily used when an investor or lender is deciding whether to invest in or loan to a company.
For simplicity, you can consider your D/E ratio to act something like a credit report and debt-to-income ratio. When you apply for personal credit, lenders look at your current financial situation, including your regular debt, income and overdue debt. These numbers let the lender know whether or not they are likely to get their payments.
By calculating your company’s debt to equity, potential investors and lenders can see how much debt you have, how you use that debt and whether you’re a good investment. In short, it helps them see just how risky doing business with you could be.
What Is Considered Debt?
When it comes to calculating debt to equity, not all items are considered debt — at least not current debt. Some portions are indicated as long-term debt, which is not a factor in the debt-to-equity ratio.
For example, if your company owes $10,000 and $2,000 of it is due this year, only that $2,000 should be added to your liabilities to determine your D/E. Any deferred or long-term debt should only be a part of the equation when it becomes payable.
Some examples of items that are calculated in the D/E ratio include:
- Lines of credit
- Notes payable
- Bonds payable
- The portion of long-term debt that’s due now
Good To Know
It’s important to understand that having company debt is not a bad thing. Businesses need money to operate, and that money often comes through taking on debt. Investors and lenders expect to see this, so there is no need to worry in that area.
What Is Equity?
Equity is used throughout the investing world, and its meaning varies depending on the specific use. For example, when speaking in terms of mortgages, equity refers to the amount that the homeowner currently owns. In business, equity refers to the amount of money shareholders would receive if the company liquidated its assets and paid off all of its debt.
How Do You Calculate the D/E Ratio?
The debt-to-equity ratio is calculated with this formula: D/E = Total Debt / Shareholders’ Equity.
For a company that has $10,000 in liabilities and $7,500 in shareholders’ equity, the calculation would be as follows:
D/E = $10,000 / $7,500 = 1.33
What’s a Good Ratio?
The answer to this question can vary between businesses and industries. For most businesses, the debt-to-equity ratio should not exceed 2.0. This means that the company owes twice as much in debt as it has in shareholder equity. Ideally, you want to keep it at 2.0 or lower.
How To Achieve a Good Debt-to-Equity Ratio
When your company needs money, you have two choices. You can look for lenders and investors, or you can sell equity. Both options have advantages and disadvantages, and it’s important to understand these to make the best decision.
Taking on debt can help you achieve your current financial goals, but it also means that you have more bills to pay. For the length of your repayment term, you will have to ensure you make your payments. Otherwise, you’ll end up with bad debt and on the road to possible financial destruction.
Selling equity, though, means selling off more of your company. The less you own, the less control of the company you have. Additionally, you’ll be paying more of your profits out to shareholders.
The key to a good debt-to-equity ratio is finding the balance between these two options. After calculating your debt-to-income ratio, you can determine if you need to sell more equity, borrow more money or stay the course you’re currently on.
Frequently Asked Questions About D/E RatioHere are some of the most frequently asked questions about having a good debt-to-equity ratio.
- How do I know what my debt-to-equity ratio should be?
- The ultimate way to know is by discovering what the lender or investor you're hoping to work with is looking for. However, that's not always possible if the information is not readily shared. When this is the case, it can help to research other companies in your industry to learn what their D/E is. This can often give you a good indication of whether yours is good or if it needs work.
- Besides loans and investments, is there any other use for the debt-to-equity ratio?
- The D/E ratio is excellent for determining your business's financial health, so it can be helpful in other ways. For instance, it can help members of management choose whether or not it's safe to start any additional projects.It can also help companies create a financial plan for the year and decide if it's safe to take on more debt. Any task, strategy, or project that requires a financial overview can benefit from knowing the debt-to-equity ratio.
- What does it mean if a D/E ratio is a negative number?
- In short, it means that the company owes much more money than the total shareholder equity. To lenders and investors, it indicates that the company is likely on the verge of bankruptcy and would be a very risky investment.
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- Ohio University. 2020. "Why the Debt-to-Equity Ratio Matters in Capital Structure."
- Corporate Finance Institute. "Debt to Equity Ratio - How To Calculate Leverage, Formula, Examples."
- Bankrate. "Best Home Equity Loan Rates in May 2021."