What Does My Debt to Equity Ratio Say About My Business?
A company’s debt to equity ratio is a debt ratio that is used to measure your company’s financial leverage. It is calculated by dividing a company’s total liabilities with its stockholders’ equity. This debt to equity ratio will indicate how much debt a company has and is using to finance its assets with relation to the amount represented in a shareholders’ equity.
A debt to equity ratio for a company or business allows prospective investors, clients, or even the owners of the business or company itself to see where they stand in terms of their leverage. Less debt leverage is often a good sign of a low risk company or business while high debt leverage is the tried and true mark of a company or business that is volatile.
Breaking this down more simply, debt is easy. A debt is something outstanding, something you owe, something that is not yours that you have temporarily. This is often capital in some form, be it a loan or a line of credit or something along those lines. Equity is the value of shares issued by a company to their shareholders at the end of each fiscal session. The more equity a company has, the larger their dividend payouts will be to their shareholders. The less equity a company has, the lower or smaller their dividend payouts will be to their shareholders. The upside is that dividends can vary from session to session, so one low session does not mean the company is headed for failure. It could mean they’re in a rut and that the next session will pay out more. It’s important to have long-term thought when approaching these matters.
The formula for calculating debt to equity ratios is more clearly represented as debt – equity ratio = total liability / shareholders’ equity. The result of this formula is most commonly expressed as a number or as a percentage.
Calculating a company’s debt to equity ratio is often referred to as risk or gearing. A debt to equity ratio is often one of the better indicators of a company’s health in the industry it is operating in. The higher the ratio is, the worse of the company or business is likely to be. The lower the ratio is, the better off or more successful and lucrative the company or business is likely to be. But, when comparing numbers, it’s important not to compare them arbitrarily from company to company or business to business. If you want to analyse the debt to equity ratios of companies, do so with companies in the same industry. Cross-industry analysis will only end badly and give you an unclear idea of who is doing well and who is not.
What Does Debt To Equity Ratio Mean For A Company?
Because debt to equity ratio measures a company’s debt with relation to the total value of its stock, it is most commonly used as an indicator of how much debt a company is taking on as leverage, meaning how much debt they are taking on in an attempt to increase their value by using this borrowed money to fund projects, make other investments, or improve the business in other ways. Companies that take on a lot of debt often do so for the benefit
of their business. This debt can be taken on to hire new employees, to renovate, or to expand the business to other branches or create more franchises. These debts, when spent in a way that was well thought out and calculated, often pay off and they are able to be repaid without issue. But when these debts are made in poor investments that show no return, it’s harder to pay the loans back off, therefore assets must be sold off, employees must be laid off, or the company may even have to claim bankruptcy.
When a debt to equity ratio is high, it usually means that a business has been very proactive with using debt to finance its growth. These kinds of practice companies and businesses are usually classified as high risk, as taking on too much debt has the potential to end very badly if investments fall through, projects don’t pan out, or improvements have no return. This also means that the company or business’s earnings will not be as consistent as a company whose debt to equity ratio is lower. These volatile earnings are a result of the additional interest expenses associated with taking debt on.
While these companies and businesses with high debt to equity ratios are classified as high risk and can scare away potential investors, these practices have the potential to yield remarkably high earnings. If debts taken on are done so with foresight, proper planning, and sound business acumen, they could pay off spectacularly and earnings could rocket. If earnings are high, that means dividends paid out to shareholders also increase. Shareholders will always benefit when a business or company’s earnings are substantial.
Alternatively, if the debts taken on begin to outweigh earnings, the company or business suffers and so do the shareholders. Their dividends get smaller and, if the situation becomes too dire and too much debt was taken on, the business or company may file for bankruptcy, which would ultimately leave shareholders with nothing.
What Does Debt to Equity Ratio Mean For A Person?
Not only is the debt to equity ratio applied to companies and businesses in their finance, it is also taken into consideration with individuals when they are applying for loans. This branch of the debt to equity ratio takes into account the dollar amount of debt an individual has per dollar of equity they have. This debt to equity ratio on an individual basis is incredibly important when it comes to considering an applicant for a loan because it contributes directly to the lender’s confidence, or it can show them they are a bad investment and not to loan them money. If a person has a high rate of debt to equity ratio, lenders are likely to steer clear of loaning them money for obvious reasons. Those with a lower rate of debt to equity ratio are more likely to be considered desirable as someone to give a loan to because they are a low-risk client. It also means that, because they don’t have as much debt, they’re more likely to pay back their loan at the mutually agreed upon rate within the specified time frame of repayment.
High risk people are often kept at arm’s length from banks and creditors because they are risky investments, and while some risky investments do pay back handsomely in a timely fashion, most do not and then the investor or institution loses their investment. That’s bad for business on a number of levels. Low risk people are most likely to receive loans and investments because they are a sure thing. You give money, you get that money back, often with interest and in a good, fair amount of time.
Considerations For Analyzing Debt to Equity Ratio
When analysing a company or a business’s debt to equity ratio, it’s important to take into consideration the industry of the company you are analysing. If you intend on comparing its ratio with another company, it’s safer to stay within the same industry because not each industry in commerce operates on the same principles when calculating their own unique debt to equity ratio. For example, in a capital intensive industry such as auto manufacturing, their debt to equity ratio will be closer to or slightly above 2. In industries that are not so capital intensive, such as computer manufacturers, their debt to equity ratio will be under 0.5. This is why it’s important to compare ratios within the same industry, otherwise you will end up with two vastly unrelated numbers and a poor reading.
Another consideration to keep in mind when analysing debt to equity ratios is the section that outlines a company’s or a business’s total liabilities. Different companies and businesses will have different things that they consider liabilities and that will affect their ratio directly. While some companies will include comprehensive lists of liabilities in their statements, others will only include a list of debts, such as loans or debt securities, as liabilities. Comprehensive lists of liabilities can include unearned revenue, long-term debts, short-term debts, and things of that nature.
When looking over a debt to equity ratio, it is important to remind yourself not to use it as the only figure to determine a company’s or a business’s current standing. You will need to factor in other ratios and performance metrics as well to get a better overview of how well they are doing or how poorly they are doing. It is also crucial to analyse each component of the debt to equity statement so you have a clearer idea of the bigger picture. It will allow you to see what a company is and is not including in the statement, which obviously will have a tremendous impact on the final number of their statement.