What is Debt to Equity Ratio? – Master of Accounting Degrees

Those you approach to finance your business activities are interested in how much of your current capital comes from creditors or you or fellow owners. Your enterprise’s “Debt to Equity Ratio” helps answer the question.

Whether your firm’s ratio is too high or too low depends on the type of business you conduct and whether you’re trying to lure investors or assure creditors.

The Formula

The Debt to Equity Ratio measures the amount of debt you carry for every dollar of equity. To calculate the ratio, divide the total liabilities by the total equity.

Liabilities refer to all the monetary claims against your firm, debts you owe and potential financial losses. You acquire debt by borrowing money and being responsible to repay it, usually with interest. Amounts owed on bills for trade credit also go into total liabilities. Some definitions of the ratio use only long-term debt for liabilities.

Equity is the difference between the value of assets and liabilities. A firm’s assets include land, buildings, equipment, inventory, accounts receivables (amount that are owed to the firm) and cash. Equity represents the value of the owners’ stake in the company.

For example, if your company has $4,000 in liabilities and $6,000 in assets, you have $2,000 of equity. Thus, your ratio is 4000/2000, or 2. This means you have debt or other liabilities of $2 for every $1 of equity.

A Risk Barometer

Investors and lenders use debt to equity to forecast whether you’ll default on your debt obligations. Your firm’s failure or inability to pay debts can drive you into bankruptcy, sometimes involuntarily at the initiative of your creditors.

A high ratio, such as 5 to 6, generally means your business already relies significantly on debt for its activities. It also suggests your firm has trouble generating cash flow from your operations because of a poor income stream or inefficient business practices.

Creditors use your default risk to decide whether and on what terms to extend credit to your venture. A higher ratio can translate to higher interest rates. Lenders might, as a condition of the loan, limit the amount of debt you carry and what you can borrow from other sources.

Risk-adverse investors may stay away from firms with high ratios because they fear the likelihood of no return on their investments. High debt payments eat into profits. Further, if the firm is liquidated, creditors get paid first and the equity owners receive what, if anything, remains.

Industry Influences

For some companies, significant debt appears normal and by necessity. Manufacturers typically carry high debt to equity ratios to acquire and replace equipment, plants and land. These businesses, though, often tend to have a steady, consistent income stream. Therefore, a high ratio might not necessarily ward creditors and investors away. Financial institutions and firms typically have ratios running between 10 and 20.

Software developers and other technology-based firms typically see ratios at or lower than 2. These companies require fewer, smaller and less-costly assets. Research and development firms also have lower ratios, but might not have as consistent a revenue stream.

The Problem With a Low Number

Some investors cringe at a low debt to equity ratio. A number well south of 1 signals to investors a significant reservoir of idle cash that neither grows the business nor is paid as dividends.

To achieve the right mix of debt and equity, consider your industry, business needs and the risk tolerance of those from you who seek funding.