How to calculate debt to equity ratio?
How to calculate debt to equity ratio is an extremely important piece of knowledge to have as a finance manager, business owner, or professional.
The metric has the ability to give a clear picture of the financial leverage of a company, especially in relation to long-term debt. Knowing how to find debt to equity ratio can go a long way in helping improve the company’s overall performance.
What is the debt-to-equity ratio?
The debt-to-equity ratio is essentially a metric that provides a clear picture of the financial leverage of a company.
It is a financial ratio that is commonly used by investors and bankers to tell how good a company is at using debt to finance its operations.
Also abbreviated as the D/E ratio and the gearing ratio, the debt-to-equity ratio gauges business health by comparing total liabilities with shareholders’ equity.
The debt-to-equity ratio is an important metric for determining financial leverage, business health, attractiveness to banks and investors, and the difference between the borrowed funds and the amount the owner can cover.
Related read: How does financial liability function in an acquisition?
How to calculate debt to equity ratio for your business?
To calculate debt to equity ratio you need to compare two metrics - total liabilities and shareholders’ equity. Total liabilities are the summation of all the money that your company owes to external creditors, including long-term debt.
Shareholders’ equity is the difference between assets and liabilities. To find debt to equity ratio you must divide total liabilities by shareholders’ equity. The formula you will use will be:
Debt to equity ratio = total liabilities / total shareholders’ equity
To better understand this let’s use an example. Let’s say your company has the following numbers:
Total liabilities = $350,000
Shareholders’ equity (total business assets - total business liabilities) = $320,000
This means your debt-to-equity ratio will be calculated as:
Debt to equity ratio = total liabilities / total shareholders’ equity
Or, Debt to equity ratio = 350,000 / 320,000
Or, Debt to equity ratio = 1.09
Related read: Good debt vs bad debt - What are the differences?
Why calculating debt to equity ratio is important for your organization
1. Provides a snapshot of a company's financial leverage
The debt-to-equity ratio is particularly important for gauging the financial leverage of a company.
It is an important metric that banks, investors, and other financial institutions use to determine how well a company has been using debt to finance its operational expenses.
It reveals how good a company is at balancing its costs and profits. Lenders may choose to calculate debt-to-equity ratios to gauge exactly how fruitful their investment will be in your company.
2. Help to identify potential problems with a company's debt levels
Another important internal reason why knowing how to calculate debt to equity ratio is important is because it helps identify problems with a company’s debt levels.
The debt-to-equity ratio gives companies an idea of how well-balanced debt financing is with profits generated.
It tells you when and whether the company has taken on too much debt, in which case the financial leverage of the company will be weakened.
3. Helps to assess the riskiness of its financial position
The debt-to-equity ratio is an important signifier of how risky the financial position of a company truly is. Companies aim to finance their operations with a delicate balance of funds and debt.
The balance of these two is shown by the debt-to-equity ratio. If the ratio is too high that might mean too much debt has been taken and the company runs the risk of not being able to pay it back.
If it is too low, however, that might indicate that the company is not making full utilization of available resources.
Interpretation of debt to equity ratio
Here are a few key pointers you can keep in mind when interpreting the debt-to-equity ratio:
High debt to equity ratio: First, a higher ratio indicates that a company is more leveraged and has more debt relative to equity. This can also mean that too much debt is being used.
Compare with peers: Compare the total debt-to-equity ratio of a company to peers in your industry. Use industry benchmarks to determine the value of your numbers.
Use in conjunction: The total debt-to-equity ratio is just one metric and it should be considered in conjunction with other ratios.
Understanding the limitations of debt to equity ratio
When learning how to calculate debt to equity ratio it is important to keep in mind that the metric does come with certain limitations. The debt-to-equity ratio is not a uniformly valued metric.
While a high debt-to-equity ratio might be common for one industry, another might call for lower debt-to-equity ratios. Given below is a list of shortcomings that the D/E ratio comes with:
1. Does not consider the type of debt a company has
The debt-to-equity ratio fails to account for the type of debt a company has. Whether the debt is short-term or long-term will have an impact on the financial leverage of the company as well.
2. Does not take into account the interest rate on the debt
Interest rates on the debts taken by a company is also not accounted for by the debt-to-equity ratio. The rates of interest also have a role to play in determining how easily a company will be able to pay loans back.
3. Does not consider the timing of the debt payments
The timing of debt payments must also be accounted for when determining financial health. The debt-to-equity ratio does not do this, however.
Whether the debt is due at the beginning of the financial year or the end will have an impact on how efficiently the company is able to pay its debts back.
4. Does not take into account the value of the collateral backing the debt
Debt is always taken against collateral. The debt-to-equity ratio fails to acknowledge this. The assets that are used as collateral will definitely have a say in the financial leverage of the company.
The bottom line
To conclude, the debt-to-equity ratio is an important metric in determining whether the financial leverage of a company is in good health or not.
Knowing how to calculate debt to equity ratio is even more important because it gives you the ability to determine for yourself whether the balance of debt financing in your company is at par with industry standards.
It also gives you the ability to gauge risk, get better loans, and improve operational costing.
FAQs
The more current your debt-to-equity ratio is the better picture you will have of your financial leverage.
The debt-to-equity ratio calculation utilizes the total liabilities of a company, including non-current liabilities.
No, accounts payable are not included in the debt section and therefore not in the calculation of debt to equity ratio.