The debt-to-equity ratio is a great tool for helping investors and bankers identify highly leveraged companies, helping them to determine whether or not to provide your company with financing. Find out everything you need to know about debt-to-equity ratio analysis here.
What is the debt-to-equity ratio?
Debt-to-equity ratio is a measurement revealing the proportion of debt to equity that a business is using to finance their assets - that is, how much the business is funded by funds that have to be repaid versus those that are wholly-owned.
The debt-to-equity ratio can be used to evaluate the extent to which shareholder equity can cover all outstanding debts in the event of a decline in business.
Limitations of debt-to-equity ratio analysis
When you’re learning how to calculate debt-to-equity ratio, it’s important to remember that there are a few limitations. Different industries have different growth rates and capital needs, which means that while a high debt-to-equity ratio may be common in one industry, a low debt-to-equity ratio may be standard in another.
For example, players in the manufacturing industry tend to have greater capital expenditures, leading to more liabilities and a higher debt-to-equity ratio. By contrast, services firms typically have a much lower debt-to-equity ratio, as they’re far less capital-intensive. As a result, comparing debt-to-equity ratio across industries may not be the best move.
Instead, comparing your company’s debt-to-equity ratio against that of your competitors may present a far clearer picture of how your company is performing, relative to your industry.
Debt-to-equity ratio formula
Learning how to calculate debt-to-equity ratio is a relatively simple process. The debt-to-equity ratio formula is straightforward, provided that you know a couple of key pieces of information. Here’s the formula for debt-to-equity ratio analysis:
Debt-to-equity ratio = Total Liabilities / Total Shareholder Equity
Let’s look at an example to see how this works in practice. Imagine a business has total liabilities of £250,000 and a total shareholder equity of £190,000. Using the formula above, we can calculate the debt-to-equity ratio as follows:
Debt-to-equity ratio = 250000 / 190000 = 1.32
This means that the company has £1.32 of debt for every pound of equity.
What is a good debt-to-equity ratio?
If your company’s debt-to-equity ratio is too high, it may indicate that your business is in financial trouble and will be unable to pay its creditors. However, if the debt-to-equity ratio is too low, it could signal that your company is over reliant on equity to finance new business, which can be both inefficient and costly, as well as placing your company at risk of a leveraged buyout.
So, what is a good debt-to-equity ratio? Ultimately, you’ll need to aim for a ratio that’s appropriate for your industry. Businesses in the manufacturing industry can expect a ratio of around 2 to 5. By contrast, technology-based businesses tend to have a lower ratio – usually 2 or below – as they have fewer liabilities. In banking, your debt-to-equity ratio analysis could yield a score of 10 to 20, but it’s important to remember that this is unique to the finance industry.
Ways to reduce debt-to-equity ratio
If your company’s debt-to-equity ratio is too high, looking for ways to reduce debt-to-equity ratio may be a good idea. One of the most effective ways to do this is to increase revenue. Then, as your company’s equity increases, you can use the funds to pay off debts or purchase new assets, thereby keeping your debt-to-equity ratio stable.
Effective inventory management is also important. Inventory takes up a significant proportion of working capital, and if you’re maintaining unnecessary inventory, it may be a waste of cash. By taking steps to improve your inventory management, you can free up some of your capital to pay off debts and boost your debt-to-equity ratio.
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