The debt-to-equity ratio measures the amount of assets made available by creditors for each dollar of assets made available by stockholders. This ratio is categorized as a solvency ratio and these kinds of ratios measure the capabilities a business has which enable it to survive over the long term.
• How to compute
To figure out a company’s debt-to-equity ratio, you divide the business’ total liabilities on the balance sheet by the amount of stockholder’s equity listed on this same financial statement.
It is a measurement of how much of the capital raised by the business has been obtained through financing from creditors and how much has been invested by stockholders. This is an important factor for parties who are interested in a company’s financial position.
Here is a simplified example:
Long term debt of 250,000 + short term debt of 250,000 = 500,000
Equity of 75,000 + retained earnings of 300,000 = 425,000
Total debt: 500,000/Total equities = 1.18 times.
This result signifies that for every dollar in equity, 1.18 is owed to creditors.
Usually this calculation is done by including both short and long term obligations, but there are also times some business’ may exclude short term debts from the equation and only include long term financial obligations in considering the debt to equity ratio (investopedia.com).
• Why debt to equity is a useful ratio
While the balance sheet itself is useful in offering some information about the financial health of a company, it cannot illuminate other kinds of financial details. By extracting information from the balance sheet and doing some calculations, it is a more accurate way to get a better picture of where a company stands from a financial viewpoint.
The debt-to-equity ratio is one of many rations which can be performed to help enlighten people who have a vested interest in the business to see specific details.
Solvency ratios are important because they demonstrate a company’s financial stability and whether or not a business can pay back any debts and interest owed on money borrowed. The debt to equity ratio shows how existing liabilities compare with invested resources which have been generated by the business. It is the result of calculating the proportion of debt to equity and this illustrates a businesses’ financial leverage (investopedia.com).
If a company has a high debt to equity ratio, it points out that a company may not have the capabilities to satisfy any long-term debt obligations. Consequently low debt to equity ratio results may mean the company is not maximizing its capital to the fullest it can be achieved for increasing profits.
• How lenders and investors use the debt to equity ratio
Creditors who have extended long term loans one kind of party who are concerned with a business’ debt-to-equity ratio. Since this ratio illuminates how well a business balances its debt to its equity it exposes any potential issues which may arise in a business’ ability to pay back their balance due.
It also acts are a measurement tool to indicate how much money a company is feasibly able to borrow over the long term and shows any financial weaknesses which may exist. If a company appears to be a risky venture, lenders will reconsider whether or not the company is too high of a gamble to lend money to. From a lender’s perspective, a lower debt to equity ratio is preferable to a higher one.
From an investor’s point of view, they preferably want to find a company with a debt to equity ratio of 1 or lower. Anything above 2 means a company is carrying larger debt and may run into trouble with high interest payments. It is important to remember though that all companies carry some level of debt, this is a normal part of business operations.
Debt to equity ratios are one of many different kinds of ratios financial analysts use when examining the financial health of a company. External parties such as investors and lenders are interested these calculations because they help determine if the company is a low or high risk venture.
The debt to equity ratio is a comparative way to determine if a company’s capital financing primarily comes from debts which need to be paid back or if it is money invested by owners or, in other words, equity.