Introduction to Debt to Equity Ratio (D/E)
Debt to Equity ratio is a financial and a liquidity ratio that indicates how much debt and equity a company uses. It shows the capital structure of the company and is calculated by dividing the company’s debts by shareholders’ equity. It is a metric that indicates the amount of financial leverage it has, in terms of having funds to cover all the debt the company owes.
Understanding Debt to Equity Ratio
Debt to Equity ratio is calculated as following:
Debt to Equity = Total Liabilities / Total Shareholders’ Equity
This financial ratio depicts the financial leverage that the company uses in its operations. Assets comprise an addition of Total Liabilities + Shareholder Equity, therefore calculating D/E is easy because all required parameters are readily available in the Balance Sheet. The ideal ratio differs across various industries and is based on how much is the debt they are borrowing against how much of their funds is theirs own truly. It generally dictates the companies’ ability to pay off its debts.
D/E provides an overview of the leverage, though to understand the true leverage of the company will require greater attention and take more parameters like retained earnings, adjustments and intangible assets and contingencies. This usually creates an ambiguity in accounts, which is why the ratio is sometimes modified by analysts to aid in easier comparison against other companies in the industry.
Highlights of Debt to Equity Ratio (D/E)
Even across industries, analysts see 2.0 as the ideal D/E ratio. This means that there is one equity instrument for every 2 debt units, which is considered healthy.
Other industries and standards, however, may reach upto 5 or 8, therefore more factors like the industry growth, competitors, and the company’s own profitability values matter.
A high D/E shows that the company is high risk. It means that they are driving their growth using funds from debt instruments. That may or may not mean that the earnings are satisfactory.
D/E ratio can also be used for personal finance reasons for small and individual businesses, especially when applying for a loan. Lenders use the ratio to determine how the payments of interests and repayment of the loan is possible in durations of loss and when income is disrupted.
