How to calculate the debt-to-equity ratio
You can calculate your own debt-to-equity ratio before applying for a loan or looking for an investor by using the following formula:
Debt-to-equity ratio = company's total liabilities/ total shareholder equity
The company's total liabilities are your company's short- and long-term debt, including things like loans, bonds, and lines of credit. On the other hand, total shareholders' equity is the money returned to shareholders if the company liquidates its assets and pays its debts off.
You can calculate the total shareholder equity by subtracting the total liabilities from the total assets. You can typically find this information and other financial metrics on the company's balance sheet.
Example of debt-to-equity ratio
To help you understand how to calculate the debt-to-equity ratio of your company, let's take a look at an example. Let's say your company has a debt totaling $100,000 and shareholder equity totaling $1,000,000.
To calculate your debt-to-equity ratio, we'll just plug the numbers into the debt-to-equity ratio formula we discussed above.
Debt-to-equity ratio = $100,000/ $1,000,000 = 0.1
What this means is that for every dollar of equity that shareholders have, the business has 10 cents in debt. This is a low ratio, meaning your company is not highly leveraged and primarily uses its own money to fund opportunities and operations.
Limitations of debt-to-equity ratio
Like any financial metric used in business, the debt-to-equity ratio has limitations that should be considered. Here are some potential limitations to keep in mind:
Different industries have different average debt-to-equity ratios because their capital structures vary.
Industries that rely on capital, such as manufacturing and tech, may have higher debt-to-equity ratios than startups because they require significant debt to finance large-scale projects. Therefore, it doesn't make sense to compare the debt-to-equity ratio of companies in different industries.
Quality of debt
The debt-to-equity ratio doesn't take into account the quality of the debt and instead treats all debt the same. However, some debt might be more favorable than others with lower interest rates. The quality of the debt can significantly impact a company's overall risk profile.
Higher-quality debt typically has lower interest rates and longer maturity periods, making it less of a financial strain on cash flow while providing the business with more flexibility. This type of debt is less risky and can be beneficial.
On the other hand, low-quality debt with higher interest rates can increase financial risk and require more immediate cash flow.
Timing of debt
The debt-to-equity ratio of a business is just a snapshot, meaning it measures a company's financial health at any given time. However, it doesn't account for the timing of debt repayments.
A company with debt that matures faster will have a higher financial risk than a company with debt spread over a longer repayment period, even though their debt-to-equity ratios are the same.
Higher potential for profits is often one of the main reasons businesses borrow money. However, the debt-to-equity ratio doesn't consider the potential profitability of a company. While a company might have a low ratio, it can still be unprofitable.
Meanwhile, a company with a higher ratio can have stronger profits.