Debt has a negative connotation. Headlines that tell us Canadian households brought $2.5 trillion in debt into 2021 are meant to trigger our anxieties.
And, some debt anxieties are warranted. In some cases, debt can harm us. Some consequences of debt—high-interest rates, loan disqualification, and even bankruptcy—are wise to avoid if you can.
But, some debt is useful. Companies, from large corporations to sole proprietorships, can leverage debt wisely to fund their business.
How can a company make sure it's doing debt the right way? One option is to track its debt-to-equity ratio periodically.
The debt-to-equity ratio might be something you've learned about in a finance class—and then promptly forgotten about. In this piece, we'll walk you through a quick refresher course on this useful calculation.
What Is A Good Debt-to-Equity Ratio?
A good debt-to-equity ratio varies by industry. But, many small business owners make similar mistakes by this metric.
First, a good debt-to-equity ratio must be accurate.
There's a degree to which "liabilities" and "equity" are broad, somewhat vague categories. The vagueness leads some business owners to leave out critical financial data points in each category. When in doubt, ask lenders what counts.
In that same vein, note the distinct qualities of different types of debt. Is it interest-bearing? Is it short-term or long-term?
Second, get comfortable with debt. If a company's debt-to-equity ratio is always low because the debt is at zero, that's not good. A good ratio gives you enough borrowed capital to fund growth.
Ultimately, a good debt-to-equity ratio is balanced. At times, it purposefully swings high to fund growth. Later, the influx of revenue pushes the ratio down again.
In general, it's good when a company's debt-to-equity ratio ranges from 0.6 to 2. But generalities matter far less than the reality of your business, in your market.
You'll want to use the debt-to-equity formula to calculate a company's leverage. This might be your own company, or it could be a current or potential investment.
In finance, leverage is a strategic investment technique that uses borrowed capital. To execute this technique, a company purchases assets with loaned funds, instead of issuing stock.
This strategy lets a company multiply its buying power beyond its current market value. When the technique works, the purchased assets amplify the company's returns to a greater ROI than it could net without them.
This amplification makes it easy for the company to make good on its initial debts. But, sometimes the assets don't generate hoped-for returns. In that case, the company might find itself on the hook for debts it can't repay.
When can you tell whether a company's initial investment in assets will pay off? Typically, if the initial investment isn't panning out as hoped, a company has some time to troubleshoot.
A series of loans, asset purchases, generated returns, and reinvestments may be the right course to chart towards sustainable profit. Yet, in other circumstances, surprisingly low returns are a sign to stop.
Leverage ratios are equations that help you track the likelihood a company will make good on its loans. It notes to what degree a company pays its expenses with debts, and how much it pays with equity.
What Is Equity?
Equity is the total value of a company's assets (both current and fixed) after you subtract the company's debts. If the company's debts are greater than its assets, equity is a negative number.
Equity in Leverage Example
Consider this leverage: the company uses borrowed capital to purchase fixed assets (manufacturing machinery, licenses). Then, it uses the fixed assets to generate current assets, either directly (inventory) or indirectly (cash revenue).
Eventually, you want the total assets to outweigh the liabilities. At that point, the company is solvent.
In a leverage ratio, equity is the variable that lets you rate the likelihood of solvency in the middle of the process. While there are a few useful leverage ratios, the debt-to-equity ratio is the most straightforward.
Some financial analysts call leverage ratios "gearing ratios." These terms are synonyms.
You might see financial writers abbreviate the debt-to-equity ratio (D/E). (D/E) is a fractional representation of the formula. Like all fractions, the debt-to-equity ratio is a division equation.
How to Calculate Debt-to-Equity Ratio
The debt-to-equity ratio calculation is, at heart, calculated division.
In its fraction form, the numerator (the top number) is the sum of all the company's liabilities. The denominator (the bottom number) is the sum of all shareholders' equity.
Define and Add Liabilities
To discover the numerator, add up all outstanding debts the company owes.
Then, add all financial obligations that might become liabilities to that number. This includes:
- Pension plans
- Employee withholdings for insurance
- Defined employee benefit plans
- Accumulated realized losses
A realized loss is when the company purchased an asset at book value, but it sold the asset for less than book value. The difference between the asset's value and its liquidation value counts towards the company's total liabilities.
Determine Shareholder Equity
If a company is transparent, you can find its shareholder equity on its balance sheet. A balance sheet is one of the three critical financial documents every company has.
A publicly traded company must maintain this balance sheet by law. But, even sole proprietorships will have this kind of document.
To determine equity, subtract all the company's liabilities from all of its assets. If the difference is a positive number, the company is solvent. If it's a negative number, the company is currently operating at a loss.
Calculate the Quotient
After you've established your fraction, divide the numerator by the denominator. That is, divide the company's liabilities by its equity. The resulting quotient is the debt-to-equity ratio.
It's easiest to parse when you set the equity to one.
So, imagine that a company's fractional debt-to-equity ratio is 5/8. That means the company would owe $5 in debt for every $8 in equity value. The quotient would be 0.625.
Financial documents may present the ratio as a fraction. Most documents use the D: E format. You'd write the ratio in the example like this:
This format is easiest for most people to read at a glance. By setting the denominator (equity) to "1," you can calculate other ratios more readily.
Debt-to-Equity Ratio Calculator
All kinds of analyses benefit from programmatic calculators. These apps and software programs get results you can use from byzantine business documents.
To determine a business' debt-to-equity ratio, take a shortcut. Why not use CMHC's debt service calculator? To use it to determine debt-to-equity, simply switch up one variable. For more information on CMHC, be sure to head over to our article on the company.
A debt service ratio is, functionally, the personal finance equivalent to the debt-to-equity ratio. When the calculator prompts you to type in your household income, type in the company's total assets value instead.
Debt-to-Equity Ratio Interpretation
First, you can use the debt-to-equity ratio to determine a company's solvency at a glance. If the ratio's less than 1.0, the company's solvent. If it's greater than 1.0, it's operating at a loss.
Then, you can also use a company's debt-to-equity ratio to assess risk. The higher the ratio, the riskier the business. A company with a truly high debt-to-equity ratio might be on the brink of collapse.
To figure out where a given company sits on this scale, conduct a thorough financial risk analysis. Financial risk analyses use several equations to predict and manage uncertainty.
There are a plethora of financial risk analysis models. Consider, too, models that assess a company's risk in international contexts.
For instance, in March 2021, mathematicians published a model to project the future value of investments. The model effectively uses companies' debt-to-equity ratios to determine probable rates of return on investment.
And, correlations among stocks demonstrated decreased equity risks.
Statisticians and data scientists often bring us deeper, more interconnected modes of analysis. Concrete, quantitative data about a company gets you more foresight every day.
Low Ratio, Slow Growth
As you analyze, remember that solvency isn't everything. When a company's debt-to-equity ratio is too low, it's probably inefficient. If a company largely pays business expenses with equity, that ties up the equity.
That, in turn, limits the company's budget for improvements. Paying at least some expenses with business loans lets a company move money faster. And, companies can take advantage of tax write-offs on business loan interest rates.
Ultimately, a high debt-to-equity ratio is worth it if it's in the service of growth. This can be initial growth, or it can be expanding and scaling.
In an ideal growth scenario, a company takes on short-term debt to generate long-term assets. The debt-to-equity ratio is high for a while, then evens out as the investment generates returns.
Know Your Industry
All that said, "high" and "low" ratios are subjective. Some industries invest more in R&D than others. Banking and financial firms pay the rent with risks. It's not unusual for large investment firms to run at a ratio of 10:1.
Still, in the majority of industries, the goal ratio is less than one. What does that mean in practice?
Debt-to-Equity Ratio in Practice
For most Canadian business owners, your company's debt-to-equity ratio comes up when you're seeking investments. Prospective shareholders use it, and other ratios, to predict the rate of return on their investment.
Banks and other lenders also consider this ratio. If a company seeks a business line of credit or a loan, its debt-to-equity ratio can determine its success.
Lenders use a company's cash flow, profitability, and debt-to-equity ratio to determine loan approval. These factors also affect a loan's interest rate.
In essence, a lender wants to know if the company can develop revenue to turn a profit. But, lenders aren't the only professionals who use debt-to-equity ratios. This equation also helps Canadians maintain their personal finances.
Debt-to-Equity Ratio for Personal Finances
You can apply a debt-to-equity ratio to your personal financial records. When you do, analysts call it a personal debt-to-equity ratio.
To determine the "equity" of your household, add up all your household's assets. Cash, banking accounts, investments, real estate, and personal property all count as assets.
Then, add up all the liabilities of your household. Debts, loans, bills, and accumulated asset depreciation count as liabilities.
Finally, subtract your household's liabilities from its assets. The difference is your personal equity. This number becomes the denominator.
As with a company's debt-to-equity ratio, your household's total liabilities become the fraction's numerator. This is your household debt.
Divide your household debt by your personal equity. The quotient is the debt-to-equity ratio for your personal finances.
If your debt-to-equity ratio is less than "1," your household is solvent. In that case, you have a good chance of being approved for a loan.
High Debt-to-Equity Ratio
The higher the debt-to-equity ratio, the higher the risk. Sometimes, the risk pays off. But, there are situations where you need to bring the ratio down.
Maybe an investment didn't generate revenue. Or, maybe you're trying to qualify for a loan. No matter the reason, three tactics can lower your ratio:
- Restructure debt
- Augment revenue
- Streamline inventory
Each option encompasses many diverse strategies. The Canadian government maintains a directory of financial services for small businesses. Find resources that help you enact any of these strategies.
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