Introduction
If you are a business owner, knowing how much of your company is loan dependent will help you assess its financial standing. You can get the information you need to make calculated adjustments to increase profitability by looking at the debt-to-equity ratio. This article explains what the debt-to-equity ratio is, shows you how to calculate it, and gives you advice on how to get it lower for your business.
Key Points to Consider:
- The debt-to-equity ratio is computed by dividing the total liabilities of a business by the total equity held by its shareholders.
- A good debt-to-equity ratio is typically less than 2.0 in the majority of businesses and sectors.
- One can reduce the debt-to-equity ratio of their company by refinancing debt, raising profits, enhancing inventory control, and paying down loans.
What is Debt to Equity Ratio?
The Debt to Equity ratio is a leverage ratio that is used to calculate the proportion of total financial liabilities and debt to total shareholders' equity. It is also referred to as the "risk ratio," "debt-equity ratio," or "gearing." Total equity is used as the denominator in the debt-to-equity ratio (D/E ratio), whereas total assets are used in the debt-assets ratio. This ratio displays the percentage of debt financing in the capital structure of a business.
Debt to Equity Ratio formula!
The debt-to-equity ratio is calculated by applying the following formula to divide a company's total liabilities by its shareholder equity:
Total liabilities / Total shareholders' equity = Debt-to-equity ratio
By Using Balance Sheet:
Both the total liabilities and the shareholder equity of the company are required. Keep in mind that assets less liabilities equals total shareholder equity. Both figures are listed on the balance sheet of your business.
Start Dividing
To calculate your company's debt-to-equity ratio, divide all of its liabilities by all of its shareholder equity using the formula provided.
Example:
Let us take an example where a company's balance sheet shows $200 million in total debt and $100 million in shareholders' equity.
- Total Debt = $200 million
- Shareholders’ Equity = $100 million
When those numbers are entered into our formula, 2.0x is the implied D/E ratio.
- D/E Ratio = $200 million / $100 million = 2.0x
The D/E ratio conceptually provides an answer to the question,
"For every dollar of equity contributed, how much in debt financing is there?"
With a debt-to-equity ratio of 2.0x, our fictitious business is therefore financed with $2 in debt for every $1 in equity.
However, a higher D/E ratio suggests there is higher credit risk due to the higher relative reliance on debt. If the D/E ratio is 1.0x, creditors and shareholders have an equal stake in the company's assets.