What You Need to Know about Debt to Equity Ratios
What is the Debt to Equity Ratio, and why is it important?
Investors and analysts use the Debt Equity Ratio to measure a company’s debt in relation to its assets and this measure tells them the ability of a company to repay the debt it is taking on.
This ratio is very important for any investors or lenders because it helps them determine the risk of loaning / lending a company (more) money for expansion and financing growth and for investors, it helps them decide if the company is going to be around long-term.
The Debt Equity Ratio is calculated by dividing Liabilities by Shareholder Equity.
The Debt to Equity Ratio is exactly that, a ratio. A mathematical calculation used to determine a company (or individual’s) financial risk, usually for long-term debt. The calculation of this ratio can be complex in large organizations, or in different industries as it’s based off the balance sheet.
The ratio is interpreted as this – the higher the ratio, the higher the associated risk, so if it’s too high, businesses will not be lent money from financial institutions at a reasonable rate which means they will be forced to approach secondary lenders and borrow money at a higher rate.
The debt to equity ratio is also used in determining the risk associated to shareholders, who hold stock in a public corporation.
As a business owner, scrutinizing your balance sheet and calculating this ratio, you don’t want to see that your business is operating only because of creditor financing. You would much rather see it operating as a result of a positive cash flow.
Businesses, and to the same extent, people who rely on borrowed money to live, survive and thrive, are not always able to make it last long-term.
While financing the growth of a business with debt isn’t always a bad thing, if the company could potentially earn more because of that financing, if the result is not increased revenue, then the value of the business might decline and the risk to lenders, increases.
For Individuals or Sole-Proprietors
We can also use this ratio in relation to our personal finances. It still equates to our Liabilities (loans, mortgages etc.) but instead of being divided by Shareholder Equity, we consider our Personal Assets (house value, cash on hand) less our Liabilities.
D/E = Personal Liabilities / (Personal Assets – Liabilities)
This ratio is used for the same reason as it is in business, for when we require money from a lender for some reason. Lenders have set figures that they use to determine if an individual is able to pay back the money they wish to borrow, based on their current earnings and asset values.
For small business owners, the personal Debt/Equity ratio will be considered for a Small and Medium Sized Business Loan or Line of Credit.
In the end, it is about being able to meet your debt responsibilities regardless if you’re earning an income or still growing your business.