The debt-to-equity ratio is calculated by dividing total liabilities by stockholders’ equity (sometimes only interest bearing debt is used). The ratio demonstrates the amount a company is leveraged, meaning how much the company funds operations through debt financing versus equity financing.
A simple comparison is mortgage financing. Typically, banks lend you up to 75% of the value of a house purchase (up to 90-95% with CMHC insurance). Using the more normal 75% would result in a debt to equity ratio of 3:1 ($3 of debt for $1 of equity).
For a business, a debt-to-equity ratio under one-to-one indicates there is less debt than equity, which tends to make the business more stable, all other things being equal. A high debt/equity ratio generally means that a company is aggressive in financing its growth with debt. This can result in volatile earnings as a result of the additional interest expense.
It also results in a higher level of risk, because the cost of the debt may be larger than the return that company generates through business activities.
The right debt/equity ratio also depends on the industry. Capital-intensive industries often have higher debt whereas service industries often have lower debt. It is key to compare your company’s ratio to an industry benchmark before interpreting the meaning behind your score.
Improving your debt-to-equity ratio often means restructuring your financing through increasing equity or decreasing the level of debt.
For more information on understanding your financial position, contact us at 204-478-7266 x110.
|This article originally appeared in the October 2011 edition of The Beal Business Advisor. The issue also included:
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