- HoneyHat

What is the debt-to equity ratio?

The debt-to equity ratio (or D/E) measures the amount of debt that a company has in relation to its capital plus retained earnings. Divide the total debt of a company by its total shareholder equity to calculate this ratio.

The formula for calculating the debt-to equity ratio is:

Shopify : Click here to launch your online business

D/E ratio = Total debt / Total shareholders equity

Example of debt-to-equity ratio

To make it clear, let’s look at an example. Let’s say a company has $800,000.00 in total debt, and $200,000.00 in shareholder equity. The D/E ratio is calculated as follows:

D/E Ratio = $800,000 / $200,000 = 4

You can also express the D/E ratio as a percentage. A D/E ratio of 4 is also 400%. For every $1 in shareholder equity, a business has $4 of debt. A higher D/E may make it difficult for companies to cover their liabilities.

Different types of debts in the D/E ratio

The D/E ratio includes all or part of the following debt types:

Accrued liabilities
Short-term debt
Long-term debt
Accounts Payable
Leases, financial agreements and other arrangements in a company’s balance sheet

The D/E ratio can be extremely useful to potential investors. This ratio helps investors understand the amount of shareholder equity already invested in a company. The D/E ratio is also used by banks to determine the leverage of a business before they approve loans or any other form of credit. This ratio is important for assessing any potential risks associated with lending money to a business.

Interpreting debt-equity ratio

A high ratio of debt to equity indicates that a company borrows more money to fund its operations. This implies greater risk. It is common for startups and fast-growing companies to have high debt-to equity ratios, as the risk involved can be substantial. Sectors like manufacturing or utilities, which require substantial investment, often have higher ratios.

A ratio that is too low could indicate an underutilization. It could also make the company look less attractive to investors. The ratio of debt to equity should be between 1.5 and 2 percent.

Tips for reducing your company’s total liability

Is your debt-to-equity ratio too high? Don’t sweat. You’re covered by these practical steps.

Increase your profit: Find ways to boost sales by promoting popular products or doing cross-selling. While identifying areas for cost-cutting, consider negotiating with your suppliers or reducing your overhead.
Take control of your inventory. This could be as easy as reviewing sales and stock data regularly. Stock up on only what you need to avoid spending money on excess inventory.
Take action on your debts: Begin by paying off your highest-interest debts first. This is called the “avalanche method”. Automate your loan repayments to make sure you don’t miss any. Do not add to your debt load by taking on more.
Talk to your bank if you need to refinance high-interest loans. Monitor market rates to determine when it’s the best time to restructure debt. This will reduce the amount of interest and overall debt you pay.

Use cases for the debt-to-equity Ratio

The debt-to-equity rate has many uses. You can use it to:

Investors use the debt-to equity ratio to evaluate the risk associated with investing in a specific company. A high ratio suggests a greater reliance on borrowing, which indicates a more risky investment.
This ratio is used by creditors to assess a company’s repayment ability. A higher ratio could indicate that the company is a high-risk borrower.
Financial analysts use the debt-to equity ratio to compare the financial health of a company with other companies in the same sector. A ratio that is higher than the average could indicate trouble.
The ratio is used by the company management to plan their financial strategy. If the ratio is too high, then they might increase equity financing in order to improve financial stability.

Leverage financial leverage by using debt-to equity ratio

It’s time to leverage your knowledge of debt-to equity ratio. Compare the ratio of your company to similar businesses in your field. This can help you to understand your financial situation.

But don’t stop here. You should also consider other metrics, such as the return on equity and net profit margin, when comparing debt-to-equity. Combining them gives you an overall financial picture.

Last but not least, monitor the D/E ratio frequently. This will allow you to spot trends and solve problems before they become serious. It will also help keep your finances in order.

Debt to equity ratio FAQ

Can the debt-to equity ratio be negative?

Yes. If a company has a negative debt-to equity ratio, it means that its interest rates on debt exceeds its investment profits.

There are many reasons why a company’s debt-to equity ratio can be negative.

The company chose to increase its debt in order to cover losses instead of using shareholder equity.
The company paid out hefty dividends instead of staying within the limits of shareholder’s equity.
After large dividend payments, the company experienced a severe financial decline.

What does a ratio of debt to equity of 1.5 mean

A debt-to-equity ratio of 1.5 means that for every $1 in equity, a business owes $1.50. This ratio is used by companies to determine the risk and reward they may face.

Is it better to have a higher ratio of debt to equity?

It depends. In sectors such as telecoms and utilities, where large investments are frequent, firms may prefer a high debt-to equity ratio. High debt-to equity ratios can be a warning sign in industries that are fast-paced, such as fashion or tech startups. A higher ratio is a sign of greater risk but also potential for greater returns.

Shopify allows you to sell online.

Get a free trial

Learn more about the benefits of a membership.

Author: Adeel Qayum

Need Help Finding B2B Service Provider?

Table of Contents