Debt To Equity Ratio Explained

What Is Debt To Equity Ratio?

This ratio is used to show the proportions of equity and debt that a company is using to finance its assets. It signals the extent to which a company can cover its debt by dividing their total debt by the total shareholders’ equity. The higher the ratio, the more difficult it may be for the business to cover all of its liabilities. If the business has a low debt to equity ratio, this means that they fund operations more through owned assets. This translates into the business being able to easily pay off what it owes if it runs into difficulties. So, in short, the ratio is an essential measure of a company’s health and financial leverage.

Types Of Business Debt

Your debt to equity ratio can include some or all of the following types of debt:

• Short term liabilities
• Long term liabilities
• Accrued liabilities
• Accounts payable
• Lease and other financing agreements

This means that it cannot contain any form of personal debts, such as credit card debts or mortgage repayments. This is strictly a concept that is used within business and does not cross into the realms of personal financing.

How To Calculate Your Ratio

Fortunately, you don’t need to be an expert accountant to work out business’s ratio. All you need is access to your balance sheet, to understand what you are looking for, and to know what to do with it. Here is a simple way to calculate your ratio.

1. The debt to equity ratio formula

The first step in calculating your ratio is to work out your total liabilities. From there, you need to add up the firm’s total shareholder equity and divide the former by the latter. To make it simple, the debt to equity ration formula looks like this: d/e ratio = (total liabilities/total shareholder equity).

For example, if you have liabilities totalling £4 million and you find that your shareholder equity equals £2 million, you calculation would be as follows: (£4 million/£2 million) = 2. This can also be expressed as 200% as your debts are worth twice the amount of your total equity.

2. What constitutes debt and equity?

Now that you have the formula, all you need to know is what your debts are made up of and the equity to include in it. Make sure you include debts such as short term and long term liabilities. For shareholder equity, you balance sheet should record this figure, so you should be able to calculate this fairly easily.

Why Calculate Your Debt To Equity?

So why is it useful to calculate this ratio? Even if you are not an accountant, it is essential for you to understand your company’s financial health, and the measure can reveal how resilient your business will be if times get harder. For example, if you have a high ratio, you could struggle to cover your liabilities if revenue falls. On the other hand, a very low debt to equity ratio could show that you are not leveraging your assets as effectively as you could be.

However, as with any ratio, this measure offers more meaning and insight when compared to the same calculation for other historical financial periods. It can show whether the ratio has risen over time, which can prompt change within the business. This increasing leverage can add an additional risk to the business and increase expenses due to the higher interest costs and debts.

The debt to equity ratio can be misleading unless it is used along with industry average ratios and financial information to recognise how the company uses debt and equity when compared to the industry. Investors and creditors will usually prefer businesses with low ratios as they are more likely to withstand a sudden spike in interest rates or an economic downturn.

Tips For Lowering Your Ratio

If you are a business owner, you will want to aim for a reasonably low ratio. If it reaches 80%, it may signal financial difficulties, so lenders may not allow you to borrow with them. If you have noticed your ratio is higher than you would like, there are a few things you can do to lower it:

• Pay off any loans – when you pay off your loans, the ratio will start to balance out. Make sure you do not take on any additional debt either (unless completely necessary), since that can raise your ratio.
• Increase profitability – you should work to improve sales revenue and lower internal costs to help increase your company’s profitability.
• Improve inventory management – maintaining your inventory to ensure no money goes to waste is highly effective for improving your ratio. Make sure you do not have high inventory levels that go beyond what is required to fill your orders.
• Restructure debt – you could consider refinancing your existing debt if you have loans with high interest rates. Restructuring when market rates are low can help to lower your ratio overall.

While we do not offer financial aid for businesses, we can help you if you are struggling with repaying your personal debts. We offer a variety of debt consolidation loans, including bad credit consolidation loans and unsecured debt consolidation loans, which can help to make managing your finances easier. We may be able to lend you the money you need to pay off your debts, giving you peace of mind when budgeting. For more information, please read our FAQs or contact us today.