The D/E ratio indicates how much debt and how much equity a business uses to finance its operations.
When people hear “debt” they usually think of something to avoid credit card bills and high interests rates, maybe even bankruptcy.
But when you’re running a business, debt isn’t all bad. In fact, analysts and investors want companies to use debt smartly to fund their businesses.
That’s where the debt/equity ratio comes in.
What is the Debt To Equity Ratio – D/E?
The D/E ratio is calculated by dividing a company’s total liabilities by its shareholder equity. These numbers are available on the balance sheet of a company’s financial statements.
Debt to Equity Ratio Formula
The D/E ratio is calculated by dividing the total long-term debts of the business by the book value of the shareholder’s equity of the business or, in the case of a sole proprietorship, the owner’s investment.
D/E Ratio = Total Debt / Shareholders’ Equity
D/E Ratio = (short term debts + long term debts + fixed payment obligations) / Shareholders’ Equity
Consider an example. If your small business owes $2,736 to debtors and has $2,457 in shareholder equity, the D/E ratio is:
How to calculate debt/equity ratio?
There are two main components in the ratio: total debts and shareholders equity’s.
The Shareholder’s equity is already mentioned in the balance sheet as a separate sub-head, so that does not need to be calculated per se. What needs to be calculated is ‘total debt’.
As the term itself suggests, total debt is a summation of short term debt and long term debt.
The D/E Ratio for Personal Finances
The D/E ratio can be applied to personal financial statements as well, in which case it is also known as the personal D/E ratio.
Here, “equitys” refers to the difference between the total value of an individual’s assets and the total value of his/her debts or liabilities. The formula for the personal D/E ratio is represented as:
Debt/Equity=Total Personal Liabilities/(Personal Assets−Liabilities)
The personal debt/equity ratio is often used when an individual or small business is applying for a loan.
Lenders use the D/E to evaluate how likely it would be that the borrower is able to continue making loan payments if their income was temporarily disrupted.
What is a good debt/equity ratio?
The optimal D/E ratio will tend to vary widely by industry, but the general consensus is that it should not be above a level of 2.0.
While some very large companies in fixed asset-heavy industries (such as mining or manufacturing) may have ratios higher than 2, these are the exception rather than the rule.
What if D/E ratio is less than 1?
As the D/E ratio continues to drop below 1, so if we do a number line here and this is one, if it’s on this side, if the D/E ratio is lower than 1, then that means its assets are more funded by equity.
If it’s greater than one, its assets are more funded by debt.
Limitations of Debt/Equity Ratio
When using the debt/equity ratio, it is very important to consider the industry within which the company exists.
Because different industries have different capital needs and growth rates, a relatively high D/E ratio may be common in one industry, meanwhile, a relatively low D/E may be common in another.
For example, capital-intensive industries such as auto manufacturing tend to have a debt/equity ratio of over 1, while tech firms could have a typical debt/equity ratio around 0.5.
The debt/equity concept is an essential one. It uses aspects of owned capital and borrowed capital to indicate a company’s financial health.
The D/E ratio can be misleading unless it is used along with industry average ratios and financial information to determine how the company is using debts and equity as compared to its industry.
Companies that are heavily capital intensive may have higher debt/equity ratios while service firms will have lower ratios.