What is the Debt to Equity Ratio?

Debt is a bit like some sugar in your coffee...

It’s fine to have little in the cup to increase the level of sweet — but overusing it can leave you not feeling great. Similarly, debt is healthy for growth in certain amounts, and the debt to equity ratio helps tell us more about a company’s diet.

This is a key distinction in corporate finance: debt vs. equity.

Debt is an amount borrowed by a person or a company that needs to be paid back at some point. Banks or other financial institutions are sometimes willing to lend money in exchange for interest they charge the borrower. Companies typically take on debt to acquire the essentials for running their businesses, including human, financial, and capital assets. Debt can come in different forms:

• Bank loans
• Secured and unsecured business loans
• Bonds
• Equipment loans

Equity, also referred to as shareholders’ equity, indicates the amount of value that’s fully owned by the shareholders, even after accounting for money the company owes. Equity is the amount of money that would go back to stakeholders in the case of liquidation of the assets and when the debts are paid off. Equity is calculated by taking the total assets and subtracting total liabilities.

Equity represents the value of investors’ stake into a company. It’s a significant financial metric to evaluate how much money the company holds outside of debts and assets.

Homeowners have equity when the home that they own is worth more than the debt owed on the home. If the home asset is worth $300,000 and the mortgage debt is $120,000, then the homeowner has $180,000 of home equity.

The debt to equity formula is the total liabilities divided by the total shareholders’ equity.

Debt / Equity = Total Liabilities / Total Shareholders’ Equity

An ideal debt to equity ratio is generally somewhere between 1 and 2 — Yet this all depends on the industry the business operates in. For example, capital-intensive sectors such as the manufacturing industries may require a larger amount of debt to finance their operations compared to an online business.

A low debt to equity ratio indicates that a company doesn’t rely too much on external borrowing to finance its business. The good thing about a low debt to equity ratio is that interest expenses are low, and it’s not too dependent on banks. The downside is it may also mean a business is missing out on opportunities to leverage external sources of funding as a catalyst for growth.

A high debt to equity ratio showcases that a firm may need to monitor its debts closely, or it could over-borrow money and put its ability to pay expenses at risk. A higher debt to equity ratio may also reveal that a firm is aggressive with regards to its financing strategy and is actively trying to grow.

There are pros and cons to high and low debt to equity ratios. However, the higher the ratio, the riskier the company tends to seem to investors. That’s because higher debt amounts tend to come with higher interest amounts. When there’s a business downturn, high interest payments could put pressure on the company.

To calculate the debt to equity ratio of a company, we need to look at its balance sheet. Companies list their current and non-current liabilities as well as their preferred and non-preferred stocks in the balance sheet. The data from the previous fiscal year is typically used for the calculation to tally up the most up-to-date liabilities and shareholders’ equity figures. Then you divide to get the ratio.

To stay in business and be successful, a firm has to monitor its level of debts. Various metrics help small and big companies keep track of their borrowings, including the debt to equity ratio. This formula helps us understand over a period of time whether the company is overusing debts to finance its operations, or on the contrary, if it relies too much on stakeholders’ equity to finance itself. Potential investors use these metrics too. While higher debt levels can increase potential returns, they can also exacerbate losses, which poses risk to shareholders.

The debt to equity ratio is a leverage ratio. Any firm that has investors or wants the option of borrowing money should watch this ratio closely. Overall, the debt to equity ratio shows the business capital structure and its strategies for funding growth, operations, and expansion over time. Lastly, this ratio may help assess how sustainable and healthy a business is.

The debt to equity ratio is one of the first financial metrics investors or banks examine to learn more about a company’s long-term financial health. A company should always monitor its level of debt over equity in order to conduct operations in the future — and be able to borrow if needed. Banks and financial institutions are reluctant to lend money to businesses that have too much debt already. And the higher a company’s indebtedness, the higher interest rate the bank is likely to charge, because banks typically want to be compensated for taking on more risk.

A debt to equity ratio can be below 1, equal to 1, or greater than 1.

• A ratio of 1 means that both creditors and shareholders contribute equally to the assets of the business.
• A ratio greater than 1 implies that the majority of the assets are funded through debt.
• A ratio less than 1 implies that the assets are financed mainly through equity. A lower debt to equity ratio means the company primarily relies on wholly-owned funds to leverage its finances. Banks and lenders would feel more reassured extending new debt to a business when its current debt to equity ratio is lower than 1.

For personal finance, debt ratios help a person understand how much debt they have and whether they can afford to borrow more money. For example, the debt to income ratio applied to personal finance can help an individual decide if he or she should ask the bank for a mortgage or a personal loan to buy a new computer or a car, for instance.

The debt to income ratio applied to an individual showcases how much personal income is used toward paying off debts. The lower the ratio would mean that an individual is able to pay off their debts in due terms. The calculation takes gross earnings, i.e. the amount you get in your bank before taxes and deductions every month and is usually expressed as a percentage. For example, if you earn $1,500 per month, you pay $400 in debt and interest payments and $400 in mortgage payments. Your debt to income ratio would be 53% including mortgages before taxes and deductions.

The debt to equity ratio is an important tool for measuring a company’s indebtedness. It can help a company decide whether it can speak to a bank to contract a loan for business growth. However, there are a few limitations to the debt to equity ratio:

• The industry is an important factor to take into account when analyzing a debt to equity ratio. Investors and banks may be comfortable with higher levels of debt in certain industries, such as the industrial sector, where investments in expensive and long-term equipment may be required, and considered appropriate to finance with debt.
• The debt to equity ratio is calculated over a fiscal year, and doesn't say much about short-term debt obligations. For that, another ratio is needed.
• To be a great indicator of a business’s overall performance, the debt to equity ratio should be calculated with additional financial ratios and metrics. For example, the “current ratio” enables investors to help measure a company’s short-term solvency.

The debt to equity ratio is an example of a gearing ratio. Gearing ratios are financial ratios that determine the degree by which a firm finances itself through shareholders or creditors’ funds. These financial metrics measure the level of debts a firm may contract to finance its operations. In short, gearing ratios let accountants and financial analysts determine which firms may be in trouble and which ones may be in a good state.

There are four main types of gearing ratios: the debt to equity ratio, the times interest earned ratio, the equity ratio, and the debt ratio. Generally speaking, a company that has a higher gearing ratio may have a financial structure that’s riskier than a firm with a lower gearing ratio.

While the debt to equity ratio measures the level of debts contracted by a company to foster its growth and operations, the times interest earned ratio — sometimes named the interest coverage ratio — takes into account the amount of income used to cover interest expenses in the near future.

The equity ratio measures the relative equity — or wholly-owned funds — of a company used to finance its assets. Compared to the debt to equity ratio, the equity ratio showcases the actual self-owned funds injected toward acquiring the assets without acquiring any debts.

Similarly, the debt ratio enables you to isolate the relative amount of debt used to purchase assets used to run a business, such as machines. Unlike the debt to equity ratio, the debt ratio illustrates the part of external debts injected toward buying the assets.

The debt to equity ratio is the most prominent gearing ratio but doesn’t alone tell investors or bankers whether a company is achieving great solvency and profitability, or if it’s at risk of bankruptcy. Taking into account the industry, the competition, and measuring the debt to equity ratio against other financial ratios can help identify potential investment opportunities.