What is the debt-to-equity ratio?

When the firm’s total liabilities are divided by total shareholder equity, the resultant is debt-to-equity ratio. The liabilities and equity can be found in the balance sheets of any company. D/E ratio tells about the financial leverage of a company. It is the computation of degree to which a company finances its running operations through debt versus funds which are wholly owned. In specific terms, it tells us the capability of shareholder equity to cap all the remaining debts in case the business is on a dip.

D/E Ratio Formula

The D/E ration can be calculated by dividing the total liabilities to total shareholder equity.

Debt/Equity or D/E = TOTAL LIABILITIES / TOTAL SHAREHOLDER EQUITY

 

Significance of Debt-to-equity ratio

The ratio tells about the debt a company owes relative to the net asset value which is basically the measure of how much a company is taking on debt in order to leverage assets. A high Debt to equity ratio is not a good sign as far as the company’s financial stability is concerned. High D/E ratio means high risk or simply put; it indicates that the company has been aggressive in growing by managing finances through debt.

There can be multiple consequences to it:

  1. A lot of debt means high potential; investors should look out for dividends
  2. If earnings are increased because of leverage and are greater than debt cost; investors are up for a benefit
  3. If the cost of debt is more than generated income, a decline in share price is ahead.

Note: The cost of debt is relative to market movement. Hence, it is not possible to judge accurately if it is going to be a profitable borrow or not.

 

Debt to equity ratio in personal finance

The debt to equity ratio can be used in personal finances as well. It is most commonly used while applying for loans. This ratio gives an idea regarding the ability of a borrower to repay the loan or what are the possibilities that the loan repayments can be made in case of a temporary or permanent financial dip.

In this case, the term equity refers to the difference between total assets value and total liabilities.

It can be represented as:

Personal debt/equity ratio = total personal liabilities / (total personal assets – total liabilities)

This ratio is mostly used by lenders to be sure of the borrower’s financial situation. In the most likely situation, a borrower is in good shape if the total assets are more than the debt. In case he/she happens to be out of the job for some time, such a situation is favorable towards their capability to repay the loan.

Another case can be of a small entrepreneur who is still the business. If they possess a good debt to equity ratio, they are considered to be in a position of repaying the loan while still growing their business.

 

Major takeaways

  1. The debt/Equity ratio gives a comparison of a company’s total liabilities to its shareholder equity. It can be used to determine the amount of leverage a company is using to be operational.
  2. Debt/Equity ratio is used by lenders to gauge the financial situation of a borrower and make a judgment regarding their repayment ability.
  3. On a general note, a high leverage ratio indicates a high risk
  4. The debt to equity ratio is relatively different for different industries. There is no perfect number which indicates the ideal performance of stocks.

 

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