Is the word “debt” a cringe-inducing four-letter word in your financial vocabulary? Does the term “equity” leave you a bit baffled? You may want to reconsider, because when they come together in the form of the debt/equity ratio, or the debt-to-equity ratio, they can help to shed some light on your business’ financial stability and help potential investors decide whether or not your company is worth their time. Not only that, but calculating the ratio is super simple. We promise!
What is the Debt/Equity Ratio and How Do I Calculate It?
If you want to get an idea of your company’s financial leverage (i.e., how much of your liabilities and equity are going towards financing your assets), then the debt/equity ratio is an easy way to find out. First though, you may want to brush up on assets, liabilities, and equity.
You can find your company’s debt/equity ratio simply by dividing total liabilities by shareholders’ equity, both amounts which are found on the balance sheet.
Debt/Equity Ratio = Total Liabilities / Shareholders’ Equity
You can also think of this ratio as a way to compare the amount of money creditors, lenders, and suppliers have committed to your business (total liabilities) against how much your shareholders have committed through their stake in the company.
So What’s a Healthy Debt/Equity Ratio?
While pinning down an exact ideal ratio of liabilities to equity is a bit of a tall order, generally speaking, a high ratio of debt to equity can appear risky in an investor’s eyes. Conversely, having a lower proportion of debt shows your company is in a stronger equity position and is using less leverage.
Carrying a large amount of debt relative to the amount of equity can indicate that a company is heavily financing its operations through debt, which could be a pathway to rapid growth. There is both good debt and bad debt, after all.
Growth is great, but if the earnings that come along with it are outweighed by the cost of debt (i.e. the interest your company now owes on that debt), then you may be putting your business at risk of financial peril down the line. (Among the worst-case scenarios: bankruptcy.)
That said, if your earnings are greater than the cost of debt incurred, then that’s great news for investors and shareholders alike. Investors are more likely to get a good return on their investment, and shareholders end up with more earnings in their pockets.
So as you can see, the debt/equity ratio is a fairly general way of looking at your company’s financial position in terms of its liabilities and equity. However, this ratio’s popularity in the world of investing means that it’s worth your while to take a closer look.