How to Calculate and Understand Your Company’s Debt-to-Equity Ratio (2024)

What Is the Debt-to-Equity Ratio?

The debt-to-equity ratio (D/E) is a ratio that measures an organization’s financial leverage by dividing total debt by shareholder’s equity. This ratio helps lenders, investors, and leaders of companies evaluate risk levels and determine whether a company is over-leveraged or under-leveraged.

Calculating Debt-to-Equity Ratio Step-by-Step

1. Calculate Total Liabilities

Look at your company’s balance sheet to find short- and long-term liabilities and calculate the debt from each.You’ll need the following to calculate:

Short-Term Liabilities: All financial obligations due within one year, such as accounts payable, monthly lease payments, payroll, short-term debt payments, and any other short-term expenses.

All you need to calculate shareholder’s equity is the number of total assets in your company and the number of total liabilities, which you calculated in Step 1.

Total Assets: A company’s assets include all items of value held by the business, such as cash, accounts receivable, inventory, and real property. After identifying your company’s assets, subtract total liabilities to find total equity. Use the following formula:

Total Assets – Total Liabilities = Shareholder’s Equity

Finally, your ratio is simply debt divided by equity. Use the following formula:

Adjusting D/E Ratio for Long-Term Debt

Long-term debt is generally much riskier than short-term debt, so some analysts prefer to analyze a company’s debt-to-equity using only long-term liabilities. To calculate the long-term debt-to-equity ratio, use this formula:

Debt-to-Equity = Long-Term Liabilities / Shareholder’s Equity

Note that you’ll still need to know the company’s short-term liabilities to calculate shareholder’s equity.

What Debt-to-Equity Ratio Means for Your Business

A debt-to-equity ratio between zero and one indicates a low-risk business that is unlikely to default on its debt. A D/E ratio above 1 means a company uses more debt financing than equity financing. According to Warren Buffett and the Interpretation of Financial Statements by Mary Buffett and David Clark, Warren Buffett prefers investing in companies with a D/E ratio below 0.5.

However, a good debt-to-equity ratio can be as high as 2.0 or occasionally higher depending on the industry, cash flow, and company size. Larger companies can sometimes carry higher debt levels without too much risk.

“A high debt-to-equity ratio could indicate a company will not be able to generate the cash needed to pay its creditors. However, these companies need to be compared to other companies within their same industry,” Lynn Sudbury, CPA, says. “Certain industries require a high investment in property plant and equipment. Those companies tend to have more debt related to those assets, and so their debt-to-equity ratios tend to be higher than the average.”

Pros of a High D/E Ratio

While a low debt-to-equity ratio indicates low risk, it may also suggest that a company is not taking financing that would help them grow. Financial advisor Jordan Quijano explains how wealthy individuals in the past relied on debt to build their companies.

“You look at any wealthy family—the Kennedys, the Rothschilds, the Vanderbilts—any of them have used other people’s money,” Quijanosays. “The concept of using bank’s money, people that lend them money, anything but their money, to help build their skyscrapers, their financial goals, anything . . . They used other people’s money.”

Here’s why a high D/E ratio can be a good thing:

• Drives quicker growth: If you have to finance growth with your own money, your company may have to wait long periods of time to raise enough capital. Debt allows you to finance periods of fast growth.
  
• Keeps cash open for other investments: If the cost of borrowing money is lower than the returns you’d see by investing your cash, you should be using debt to fund your business. You may not want your cash to be tied up in a non-liquid asset when you could put that cash toward money-producing investments.

Cons of a High D/E Ratio

While debt drives growth, highly leveraged companies have greater risk. Here are a few reasons a high debt-to-equity ratio is risky:

• Periods of low revenue: Some highly leveraged companies rely on consistent revenue to cover the costs of debt. However, unexpected declines in revenue can cause a company to default on its debt payments.

• Rising cost of debt: Companies that rely on debt to stay in business can experience serious financial trouble when the cost of debt rises. While the cost of borrowing money has been low in the U.S. for over a decade, in 2022, many companies felt stretched thin as interest rates on debt quickly increased.

Limitations of the D/E Ratio

The debt-equity ratio can be a valuable tool for evaluating a company’s financial standing, but it’s important to use other metrics as well to get the clearest picture possible. The debt-to-equity ratio does not consider the company’s cash flow, reliability of revenue, or the cost of borrowing money. This can leave investors with an obscured idea of a company’s risk level.

For example, utility companies have highly reliable sources of revenue because they provide a necessary commodity and often have limited competition. This allows companies to take on greater debt without taking on greater risk.

Additionally, many analysts use different methods for classifying liabilities and assets. Sometimes preferred stock is considered an asset, while other times, it’s considered a liability. This impacts the debt-to-equity ratio and can throw off your personal analysis of a company if you are not aware of how a particular analyst came up with the debt-to-equity ratio.

Using the Debt-to-Equity Ratio for Personal Finances

The debt-to-equity ratio is for more than just business owners. Lenders often use this ratio to determine whether an individual qualifies for a loan. The ratio highlights whether your assets are great enough to cover your debts. You can also calculate your own D/E ratio to determine if you are over-leveraged with your personal finances. Here’s how you’ll calculate it:

D/E = Total Personal Liabilities / (Total Personal Assets – Total Personal Liabilities)

While a good debt-to-equity ratio for your personal finances would ideally remain below 1.0, many homeowners hold more debt than equity in their homes. However, homes are an asset that can produce income. If your debt-to-equity ratio is high because of your home, aim to keep debt from other sources low.

Use Multiple Metrics to Calculate Leverage and Determine Risk

Whether you’re a business owner, investor, or an individual working to make smart financial choices, metrics like the debt-to-equity ratio can help you make informed decisions about where to put your money. Here are other metrics that finance experts like to include in analysis to get a complete picture of whether an individual or organization is over-leveraged:

• Current ratio: The current ratio divides the current assets by current liabilities. This ratio shows a company’s ability to pay short-term liabilities, allowing investors to assess short-term risk.
• IBD-to-EBITDA ratio: IBD stands for interest-bearing debt, while EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. This ratio is often used as an alternative to the D/E ratio because it accounts for a company’s cash flow and excludes non-interest-bearing debt. This gives a more accurate picture of whether a company has high levels of risk due to its debt levels.
• Total asset turnover: Total asset turnover highlights how efficiently a company’s assets generate revenue.
• Return on equity (ROE): ROE highlights a company’s ability to use equity investments to earn profit.

For more tips on investing and personal finance, check out the articles below:

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