The goal of the debt to equity ratio is to provide interested parties with a number representing how risky a company’s current financial position is.What is Debt to Equity Ratio?
Debt to Equity Ratio Definition
Debt to equity (D/E) ratio refers to how much debt relative to shareholder equity a company has.
The ratio is commonly used to evaluate a company's financial leverage by examining how much debt it is taking on to finance expansion activities. The debt to equity ratio does this by measuring a given company’s debt in relation to the value of its assets (in the form of shareholder equity).
Businesses can use accounting software to calculate their D/E ratio directly within the application, giving them an easy way to stay abreast of how potential investors view them.
How Debt to Equity Ratio is Calculated
Debt to equity ratio is calculated by dividing the company’s total liabilities by the total amount of shareholder equity. The amount of shareholder equity is calculated by subtracting liabilities from total assets.
There are differences in the way people determine debt to equity ratio, so it should never be the sole number by which you judge a company’s financial position. The differences typically stem from what the calculator deems a liability.
Instead of being looked at as the end-all be-all in determining financial leverage, it should be used conjunction with other leverage ratios. The combination of these ratios will give analysts a more comprehensive risk analysis of the financial growth strategy of a company.
The debt to equity ratio of some large publicly traded companies may greatly exceed those of small- and medium-sized businesses. This is because large publicly traded companies have the confidence that accompanies massive company size. The debt to equity ratio also applies to privately held companies, as they also bring in investors and finance their growth with debt and equity.
|TIP: To prove the worth of investing in an accounting software, check out these 30+ impressive accounting statistics in 2019.|
The Debt to Equity Ratio Formula
The debt to equity ratio formula is simple. It is total liabilities divided by total shareholder equity.
Debt to Equity Ratio Specifics
A good rule of thumb is the higher the debt to equity ratio, the more risk the company is taking on. This is because a high debt to equity ratio indicates that a company is financing growth with large amounts of debt. What constitutes a large amount of debt is relative to the amount of assets a company currently holds.
There is a caveat attached to the high ratio rule, though: Risk is relative, and you must keep a company’s industry in mind when evaluating its risk profile. Debt to equity ratio varies greatly between industries, with capital-intensive industries — manufacturing, oil and gas, and telecommunications, for example — generally having ratios greater than two.
This is because growth activities within these industries require a large initial capital expenditure. For example, telecommunications companies must install the necessary infrastructure, which includes laying thousands of miles of cables, to expand their services to a given area and start generating revenue.
By contrast, businesses operating within the services industry (any company that does not provide customers with a tangible good) typically carry a D/E ratio lower than 0.5, because they require comparatively little capital investment to generate revenue. Companies in the services industry don’t need to lay cable or make infrastructure investments before generating revenue. Typically, their initial expenditure is simply the office space they rent and the salaries of their employees.
The exception within the services industry is the financial sector. Financial institutions borrow huge amounts of money to generate revenue by then loaning out that money, and they typically have higher debt to equity ratios as a result. Since this is commonplace within the financial sector, high financial leverage ratios are not looked at as heavily when determining risk.
While the debt to equity ratio is an important tool in risk analysis, there are differences in how it is calculated due to the various ways to define an asset and a liability. For example, preferred stock may be listed as an asset by some analysts and as a debt by others. If it’s listed as a debt, the company’s D/E ratio will be higher and label the company as financing their growth with more risk.
The differences in calculation methods mean that investors should look at various ratios to generate a comprehensive overview of the company’s risk profile. The debt to equity ratio is not the only number to look at when considering making an investment.
The debt to equity ratio doesn’t just apply to publicly traded companies. It’s an important way for private companies utilizing debt to finance growth (via loans or other credit vehicles) to stay on top of their growth activities. Armed with the knowledge, they can go about creating comprehensive growth strategies.
Should My Debt to Equity Ratio be as Low as Possible?
In a word, no. Having an extremely low debt to equity ratio may seem like a positive; after all, less debt is always a good thing, right? That’s not necessarily true. Debt from loans is often low interest and tax deductible. Equity is significantly more expensive, where investors expect returns of up to 10 percent. Financing your business with equity as opposed to debt can be more costly and inefficient, possibly putting your business at risk of a leveraged buyout.
Even if a company is financing growth with large amounts of debt, if it leads to earnings greater than the cost of the debt (interest), then the company’s shareholders benefit. If the shareholders benefit, everyone stays happy and the company is in no danger.
Why is Debt to Equity Ratio Important?
Debt to equity ratio is important because when accurately calculated, it informs markets, shareholders, analysts and the general public about the current financial standing of a company. The ratio measures the ability of a company to repay its debts, which is of particular interest to lenders and investors.
Debt to equity ratio informs potential investors of the risks associated with investing in a given company and keeps current investors abreast of any changes in a company’s growth strategy. Shareholders can look at the D/E ratio to determine if the company is on the right growth path.
Debt to equity ratio should be considered in conjunction with other financial indicators like liquidity, solvency, profitability and operating efficiency to generate a comprehensive overview of a company’s financial health.
How Debt to Equity Ratio Relates to Accounting Software
Debt to equity ratio is an important aspect of accurately calculating how much debt a company is using to finance its growth relative to its assets. Accounting software provides users with the tools to always stay on top of leverage ratios easily.
Companies can use accounting solutions to engineer various calculations of their debt to equity ratio. Based on their current ratio, they can evaluate potential growth strategies and how they want to proceed. A relatively low debt to equity ratio may prompt them to finance with debt, while a relatively high ratio may push them towards financing with equity.
The debt to equity ratio can be an important analytical tool to determine potential growth plans for companies. If you’re looking for accounting applications, check out our accounting software category to vet potential solutions. You can also head to our page on financial services software for a wider range of financial industry applications.
Ready to learn more? Discover how a free accounting software can help your financial department become more efficient in 2019.