Debt to Equity Ratio
In short, a debt to equity ratio is a way of seeing what a company’s financial leverage is.
This is a process where a business uses debt and equity to buy more assets to finance the company. This may sound complicated, but it’s actually worked out using a simple equation. You divide your company’s liabilities by your shareholders’ equity. That’s it! That’s your debt to equity ratio.
Equation: Your Company’s Liabilities / Your Shareholders’ Equity
Understanding Debt to Equity Ratio
- So, what’s debt? It’s what you owe if you’ve borrowed money. Most businesses do this to fund their operations. The money usually comes from a bank or private investors. Typically, if you want to borrow money, you need hard assets that show you have something that can be sold, if necessary, to repay the debt.
- What’s equity? It’s a term to describe the portion of your company you actually own. Imagine you have no mortgage, you have 100% equity in your home. Simple, right?
- What’s a liability? This is all your company’s debts, including tax liabilities.
- What’s shareholder equity? This is worked out by subtracting a company’s debts and liabilities from the company’s total assets.
As an example, say you owe $200,000. Your shareholders’ equity is $165,000. This gives you a debt to equity ratio of 1.2. A low rate means your company is a less risky bet. A good ratio is anywhere between 1 and 1.5. So, if you have a 0 or near-zero ratio, it basically means a company hasn’t borrowed much (if anything).
If you have a negative debt to equity ratio, it’s usually because you have interest rates on your debts that are higher than the return on your investment. This may make you risky to invest in and could indicate that your company is financially unstable. This is more likely to occur if you take on too much debt or if you give out significant dividend payments to shareholders that are higher than their equity.
If a company uses its debt to fund its activities and purchases of assets, the company is then considered to be highly leveraged.
As such, if your company is highly leveraged, your debt to equity ratio will typically be higher. Basically, it’s a straightforward formula to show how you’ve raised capital to run/fund your business.
But, just because it’s a simple formula, it doesn’t mean it isn’t vital. It’s a crucial figure for showing investors how stable your company is and how easily you could raise more money to expand. The higher your debt to equity ratio, the more speculative an investment you are.
Different businesses will have a fluctuating debt to equity ratio because some companies need more debt and capital to operate. For example, if you own a clothing company, you’ll need to pay for materials, a warehouse, a factory, a store to sell them in, a website, etc. For instance, this kind of company will likely carry more debt than a brand that only operates online.