Definition, Formula, and Use Cases
Thinking about investing or growing your business? There are a few important metrics you need to measure. One of these is debt-to-equity ratio. This key number provides a look into a business’s health, a crucial factor for companies planning on going public. Lenders use it when making loan decisions, and investors rely on it to assess business performance.Interested? Here’s everything you need to know about debt-to-equity ratio.
What is debt-to-equity ratio?
A debt-to-equity ratio (or D/E ratio) shows how much debt a business has relative to the capital invested by its owners plus retained earnings. This ratio is calculated by dividing a firm’s total debt by total shareholder equity.
The debt-to-equity ratio formula is:
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D/E Ratio = Total Debt / Total Shareholders Equity
Debt-to-equity ratio example
Let’s use an example for clarity. Suppose a business has $800,000 in total debt and $200,000 in shareholder equity. You would calculate the D/E ratio as follows:
D/E Ratio = $800,000 / $200,000 = 4
You can also express D/E as a percentage. In our case, a D/E of 4 also equals 400%. This means that for every $1 of shareholder equity, the business owes $4 in debt. Companies with a higher D/E ratio may have a difficult time covering their liabilities.
Types of debt in D/E ratio
A D/E ratio can include all or some of the following types of debt:
Leases and other financial arrangements on a company’s balance sheet
D/E ratio is incredibly useful for potential investors. It helps them understand how much shareholder equity is already committed to a business. Banks also use D/E ratio to determine how leveraged a company is before approving loans or other forms of credit. This is crucial for assessing the potential risk involved with lending to a particular business.
Interpreting debt-equity ratio
A high debt-to-equity ratio generally means a company is using more borrowing to finance its operations, implying greater risk. This is common in startups or fast-growing businesses, where substantial risk can come with high potential rewards. In contrast, sectors like utilities or manufacturing, which require significant investment, regularly exhibit higher ratios.
Although a lower ratio is usually preferred, an excessively low one could point to the underutilization of assets. This could make the company less appealing to investors. A good debt-to-equity ratio is between 1.5 and 2.
Tips to lower your company’s total liabilities
Is your debt-to-equity ratio too high? Don’t sweat. We’ve got you covered with these actionable steps:
Raise your profits: Look for ways to increase sales, like promoting popular items or cross-selling. At the same time, identify areas to cut costs—consider negotiating with suppliers or reducing overhead where possible.
Get a grip on inventory: Implement a solid inventory management system—this could be as simple as regularly reviewing stock levels and sales data. Keep your stock lean to avoid tying up funds in excess inventory.
Act on your loans: Start by tackling your highest interest debt first—this is known as the “avalanche” method. Automate your loan payments to ensure you never miss them. Don’t add more to your plate by taking on new debt.
Refinance sensibly: If you have high-interest loans, speak to your bank about refinancing options. Monitor the market rates and strike when they’re low to restructure your debt, reducing the interest you pay and your overall debt.
Debt-to-equity ratio use cases
Debt-to-equity ratio has several uses. For example:
Investors use debt-to-equity ratio to assess the risk of investing in a particular company. A high ratio indicates greater reliance on debt financing, suggesting a riskier investment.
Creditors rely on this ratio to determine a company’s ability to repay loans. A higher ratio indicates more debt, potentially making the company a risky borrower.
Financial analysts leverage debt-to-equity ratio to compare a company’s financial health with others in the same industry. A higher than average ratio could signal trouble.
Company management uses the ratio to plan financial strategies. If the ratio is high, they may opt to increase equity financing to improve financial stability.
Using debt-to-equity ratio for financial leverage
Now that you’ve learned about debt-to-equity ratio, it’s time to leverage it. Compare your business’s ratio to that of similar companies in your industry. This exercise can give you insights into your financial standing.
Don’t stop there though. It’s crucial to pair debt-to-equity ratio with other measures like the current ratio, return on equity, and net profit margin. Using them all together gives you a full financial picture.
Lastly, keep an eye on D/E ratio often. Doing so will help you spot trends, solve problems early, and stay in good financial shape.
Debt-to-equity ratio FAQ
Can debt-to-equity ratio be negative?
Yes. When a company’s debt interest rates exceed its profits on investments, its debt-to-equity ratio will be negative.
A company can land in negative debt-to-equity ratio territory for a variety of reasons:
To cover losses, the company choose to take on more debt instead of leveraging shareholder equity.
Instead of keeping the payouts within the limit of shareholders’ equity, the company distributed hefty dividends.
The company suffered a harsh financial downturn following large dividend payments.
What does a debt-to-equity ratio of 1.5 mean?
A debt to equity ratio of 1.5 suggests that a business has $1.50 in debt for every $1 of equity in a company. This ratio is used to assess the potential risk (and potential reward) that a company carries.
Is a higher debt-to-equity ratio better?
It depends. For instance, in sectors like telecoms or utilities, where big investments are common, firms might prefer a higher debt-to-equity ratio. In contrast, in fast-paced industries like fashion or tech startups, high debt-to-equity ratios may hint at trouble. In essence, a higher ratio can mean more risk, but also greater potential returns.