Debt to Equity Ratio
What is Debt to Equity Ratio?
Debt to equity ratio is a term used in corporate finance and describes an important way for companies to evaluate their financial leverage. In other words, this ratio, also called a gearing ratio, measures how much a company is financing its operations by taking on debt compared to using its own shareholder equity or wholly owned funds. The debt to equity ratio helps analysts, investors and lenders determine whether a company is economically stable and, consequently, whether the business is worthwhile to invest in or lend money to. It should be a key part of your bookkeeping plan.
If you're looking to raise money for a business, or start a business, it's a term you should be aware of.
How is Debt to Equity Ratio Calculated?
To calculate a company’s debt to equity ratio, you divide the total amount of the company’s long-term debt by the value of its shareholder equity (i.e., the shareholders’ stake in the company after debts will be paid off). Simply put, this ratio is a company’s debt divided by its equity. This indicates what a company's future obligations are (as listed on its balance sheet) compared to its worth.
The debt to equity ratio highlights the relationship between a company's reliance on debt and its ability to meet financial obligations. Therefore, this ratio is considered an extremely important metric to determine a company’s valuation. It’s not surprising, then, that this ratio is frequently calculated and analyzed.
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What is considered a good debt to equity ratio?
Investors, shareholders and lenders prefer that businesses have a lower debt to equity ratio, given that debt is viewed as inherently risky. A low debt to equity ratio means a lower risk of loan default for lenders. For shareholders, a lower ratio means a lower probability of bankruptcy if there is an unforeseen economic downturn. A company that has a higher debt to equity ratio may have difficulty getting additional funding from lenders, investors or shareholders.
So, what exactly is considered as a low or high ratio? Well, first it’s worth noting that debt to equity ratios vary by industry; some industries, like fixed-asset industries (e.g., manufacturing, mining, etc.), rely more on debt financing than others, so their ratios may be higher. In general, though, the ideal debt to equity ratio is recommended to be no higher than a level of 2.0.
A company whose debt to equity ratio is 2, for example, indicates that two-thirds of the company’s capital financing is from debt while one-third is from shareholder equity. This means that the company borrows double the amount of funding than what it owns (e.g., 2 units of debt for every 1 unit of equity). This company's management may try to aim for a lower amount of debt for a more favorable debt to equity ratio. This way, the company won’t worry about defaulting on its loans.
In comparison, a debt to equity ratio of 1 signifies that investors and creditors have equal stakes in the company’s assets. As previously mentioned, creditors and lenders view a higher debt to equity ratio as risky, as it indicates that the company’s operations have been funded more by creditors than investors. This could mean that investors don’t have as claim on the asset as creditors do, which could suggest that the company isn’t performing all that well and therefore isn’t a good investment.