Companies are constantly looking to measure their financial health, in myriad ways. Share price, gross revenues, net income, labor costs, and operational costs are usually at the front of the line when businesses take their financial pulse.
Perhaps the most important metric to a company is its debt-to-equity ratio. Why? Because an accurate debt to income calculation can help a company weigh its ability to repay its financial obligations, and how quickly it can do so. In contrast, financial lenders and investors also rely on debt-to-equity ratio to weigh the risks of steering money into a company.
After all, debt is a double-edged sword for businesses.
On the upside, companies need to borrow the money needed to get their company up and running, and keep it that way. On the downside, debt is a steady, looming presence for companies, and the more quickly it's measured and paid off, the sooner the company can get on with bigger and better things, like creating better products and services that boost revenues and increase its stock price.
Thus, knowing what debt-to-equity ratio is, and how to properly calculate it, should be a big priority for any growing company.
What Is Debt-to-Equity Ratio?
Debt-to-equity ratio, also called D/E ratio, is a common metric used by financial analysts to measure a company's financial health. It does so specifically by calculating the amount of corporate assets that are financed through borrowing and debt. You'll find both a company's debt and equity figures on a company's balance sheet.
Economists also refer to the debt-to-equity ratio as a company's risk ratio, or its debt-equity-ratio. The debt-to-equity ratio is not to be confused with debt-to-assets ratio, which relies on total firm assets as a calculation benchmark. Instead, a proper debt-to-equity ratio measurement relies on total equity.
Calculating the debt-to-equity ratio isn't all that complicated (it's just debt divided by equity - more on that below.) What can be complex is ascertaining exactly what types of debt a company holds, as there can be multiple debt models.
Potential debt obligations held by a company include:
- Long-term debt - Any corporate debt that extends beyond 12 months (bonds, lease contracts, and/or pensions and post-retirement debt.)
- Short-term debt - Any corporate debt that does not extend over 12 months (short-term bank loans, employee wages, or income taxes.)
Outcome-wise, if the debt-to-equity ratio is advancing, it means a business is overly reliant on loans and credit, and less reliant on sales and revenues - a risky scenario for a company of any size.
Besides the obvious threat of not being able to make good on all of that debt, there's also an increasing credit risk in the form of a "no" or "low" confidence level by lenders and investors to hand over any more cash. That's because creditors prefer companies with lower debt-to-equity ratios as that scenario usually means their investment in the company is stable and secure, rather than risking a high-risk proposition with a company's high debt-to-income ratio.
By and large, companies should aim for a debt-to-equity ratio of 1.0, meaning that the firm holds an equal balance of debt to equity. In a perfect world, though, a low debt-to-equity ratio - say, 0.30 - is better, as it indicates the firm has not accumulated a lot of debt and doesn't have to face onerous loan/credit interest payments, which is always good for the corporate bottom line. Lenders and investors tend to favor companies that demonstrate they're using less leverage and that they hold a more solid equity position.
Obviously, a business wants its income to exceed its liabilities. But if that doesn't happen, and debt exceeds assets, that's a big red flag for a company (especially a smaller, newer one) and could mean a company can't pay its debts.
That's why, when evaluating a company's overall financial health, and its debt burden, a debt to equity is a due diligence necessity for a company, and needs to be constantly measured.
How to Calculate Debt to Equity
As noted above, calculating a company's debt to equity is clear-cut - just take the firm's total debt liabilities and divide that by the firm's total equity.
Debt-to-Equity Ratio = Total Debt / Total Equity
Economists call this metric a "financial leveraging ratio" or "balance sheet ratio", i.e., metrics that are used to weigh a business's ability to properly manage its debt obligations.
Debt-to-Equity Formula Example
Here's an example of debt-to-equity ratio, in real-world terms:
A large business holds $35 million in bank loans and holds a $15 million mortgage on its downtown office building. Firm stockholders have added $120 million to the company's coffers.
With these numbers in mind, you would calculate the company's debt-to-income ratio as follows:
.5 + $50 million in total debt / $120 million in shareholder equity
Once that calculus is complete, the firm holds a debt-to-equity ratio of 0.42, meaning that for every $1 a company has in equity, the firm also has .42 cents in leverage.
It's helpful to remember that debt-to-equity ratio is a company's short-term debt and long-term debt added together, along with any other fixed payments, divided by stockholder equity.
Or, debt-to-equity ratio = short-term debt plus long-term debt plus any fixed payment debts divided by stockholder equity.
When Would You Use Debt-to-Equity Ratio?
When you apply debt-to-equity ratio to your bottom line, and who you are as a company, is almost important as why you calculate debt-to-equity ratios.
For example, you likely wouldn't want to have a high debt-to-equity number when you're about to apply for a big bank line of credit.
That's because financial institutions use debt-to-equity ratio to weigh approving that line of credit to your company or not. Banks and lenders have a good sense of a sector's or industry's financial health, and they know what a good debt-to-equity ratio should look like for a company in your industry.
Consequently, if you're applying for a major line of credit, but your debt-to-equity ratio clocks in high on the debt side, your lender's calculations will likely show that your company isn't a good credit risk.
Or, if your publicly-traded company is just coming off a major stock repurchase program, you might want to hold off on any big loans or lines of credit. Why? Because the way the Generally Accepted Accounting Principles (GAAP) work, accountants view share buybacks as a risk - they see the share repurchases as a reduction in a company's reported value of stockholder equity, which would amplify debt in a company's debt-to-equity ratio.
Debt-to-equity ratios also have may have different impacts depending on the industry where a company resides.
For instance, high capital-intensive industries, like automobile manufacturing, oil production and refining, steel production, telecommunications and transportation sectors, often have higher debt-to-equity ratios than low capital-intensive industries, like service industries where skill and labor may compensate for capital. Industries that require abundant capital to buy land and buildings or erect structures (like oil rigs in the energy industry) will likely have higher debt-to-equity ratios as they require more cash to build their businesses.
Consequently, any reading into a company's debt-to-equity ratio should be measured in a context of what industry the firm resides in, and whether or not it's in a capital-intensive industry.
A good calculation of debt to equity provides lenders and investors with a clear-cut method to screen a company for red flags and risk factors that may demonstrate a company holds more debt on its balance sheets than it can handle.
It's not a perfect calculation, but it does give lenders and investors a "shining light" on a company's financial health, and into its potential for producing a strong stock price and for paying all its debts.
Also, a proper debt-to-equity review by a company can reveal where it stands financially, and led the firm to take the steps needed to better balance its debt obligations with its standing equity.
In that regard, debt-to-equity ratio is an extremely valuable financial metric.