A debt-to-equity ratio is a number calculated by dividing a company’s total debt by the value of its equity.
A debt-to-equity ratio is a data point used by investors and lenders to assess a company’s financial solvency. This number suggests how well the company would be able to pay its debts if business slowed down. A company with a low debt ratio tends to be in better financial health than a company with a high debt ratio.
The formula used to calculate a debt ratio is simple. Divide the company’s total liabilities by its equity. For example, if a company has debt of $500,000 and investments from investors worth $1 million, its debt ratio is 0.5. If this business has debt of $500,000 and investor investments worth $25,000, its debt ratio is 20.
The debt ratio formula also works in personal finance. Simply replace equity with net worth. Someone who has $10,000 credit card debt, a $250,000 mortgage, and a $20,000 car loan has $280,000 debt. If this person has a net worth of $1 million, they have a personal debt ratio of 0.28.
As with businesses, maintaining a low debt-to-equity ratio increases an individual’s chances of qualifying for loans. This also applies to small business loans they want to take out to fund a project or expand a business. Lenders want borrowers to be able to repay what they borrow.
Understanding how a debt ratio works and how to calculate it can be useful for people who want to quickly assess the financial situation of a business or their own. As an investor, it is useful to consider the risk of each investment. A company with a low debt ratio usually has many investors who have seen the profit potential in the company.
As a business owner, understanding the ins and outs of debt ratios is helpful when it’s time to apply for a loan or establish a line of credit. The business owner can make better predictions about which loans to apply for and if they are likely to qualify.
What counts as a good debt ratio depends on the company and industry being examined. Some industries are more dependent on debt financing to finance the business, so investors may be more willing to accept a higher number for companies in one of these industries. Most companies try to keep their debt ratio below 1.
The lower the number, the fewer liabilities the company has. A company with a higher debt ratio may not be as attractive to investors as it tends to be riskier. Worse still, a company with a negative debt ratio may be close to bankruptcy because it has more liabilities than assets.