The Debt-to-Equity Ratio Explained

Published on
November 17, 2023
Written by
Aaron Oh
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The Debt-to-Equity Ratio Explained
Know the importance of the debt-to-equity ratio in financial analysis. Learn how it helps you measure your company's financial health and risk.
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Whether you're evaluating your own business, studying a stock, contemplating an investment in a company, or even envisioning a career in a flourishing organisation, there are fundamental concepts that can guide you in making informed decisions. Among these essential factors, the Debt-to-Equity (D/E) ratio holds significant importance.

What Is the Debt-To-Equity Ratio?

Let’s start with an example.

Say you want to buy a new computer for SGD 3,000. You have SGD 1,000 in your savings account (that’s your equity). To cover the rest of the cost, you're considering taking a personal loan of SGD 2,000 (this would be your debt).

Now, let's calculate the Debt-To-Equity Ratio for your PC purchase:

Debt-To-Equity Ratio = Money you borrowed / Money you’ve earned and saved

Debt-To-Equity Ratio = SGD 2,000 (debt) / SGD 1,000 (equity)

Debt-To-Equity Ratio = 2

In this example, your Debt-To-Equity Ratio is 2. It means for every SGD 1 in your savings (equity), you've borrowed SGD 2. This ratio tells you how much you're relying on borrowed money compared to your own savings for this purchase.

Just like in the business world, if your ratio is high, it suggests you're using more debt to finance the purchase, which can carry more financial risk. If the ratio is lower, it means you're using more of your savings and less debt, which can be considered a financially conservative approach. The ideal ratio depends on your financial goals and comfort with debt.

Now that you know what debt-to-equity ratio is, let’s look at how it’s actually defined. 

Understanding Debt-To-Equity Ratio

When considering getting money for your business, equity financing is like a heavyweight champion—it's powerful but takes time. If you're in a hurry, waiting for investors might not be your quickest option. Also, giving away a part of your business isn't always the smartest move. While there are benefits to equity financing, understanding when to use it requires staying informed about your company's finances and making strategic decisions. This is where the D/E ratio becomes crucial.

The Debt-To-Equity Ratio (D/E) is a tool to gauge a company's financial health and assess whether an investment is worth considering. This ratio, also known as the "debt-equity ratio," "risk ratio," or "gearing," is a measure of how a company's capital is structured in terms of its equity and debt. In practical terms, the Debt-To-Equity Ratio shows you how much debt a company has relative to its owners' initial investments and any retained earnings over time. Here, your retained earnings are essentially the profits you've held onto instead of distributing as dividends. These earnings serve as an internal source of funds, helping you reinvest in the company's growth or cover future needs. Keeping an eye on your retained earnings over time provides insights into your ability to generate profits and sustain growth without relying heavily on external financing.

Unlike some other financial ratios, the D/E ratio focuses on comparing a company's total debt (both short-term debt and long-term debt) and total financial liabilities to its total shareholders' equity. Instead of using total assets, it uses the company's total equity as the denominator. This explains whether a company leans more towards debt or its own finances.

Now, let’s look at the Debt-To-Equity Ratio Formula and how to calculate Debt-To-Equity Ratio.

Debt-To-Equity Ratio Formula:

Debt-To-Equity Ratio = Total Debt (How much money the company owns) / Shareholders’ Equity (The owner's stake in the company). 

Here, the total debt is the company's debt obligations, typically found on the liabilities side of the company balance sheet. The shareholders' equity is what's left when you subtract all the company's debts from what the owners have invested and earned over time. It's like their financial share in the business.

How to Calculate Debt-To-Equity Ratio?

Let's gather the financial information for ThousandTech Solutions:

Total Debt as mentioned in the Company Balance Sheet: SGD 5,000,000

Shareholder Equity: SGD 10,000,000

Now, we can calculate the Debt-To-Equity Ratio for ThousandTech Solutions:

Debt-To-Equity Ratio = SGD 5,000,000 / SGD 10,000,000

Debt-To-Equity Ratio = 0.5:1

In this example, ThousandTech Solutions has a Debt-To-Equity Ratio of 0.5. This means that for every SGD 1 of shareholder equity, the company has SGD 0.5 in debt.

Now, let’s look at the financial information for another company, BrilliantTecQ:

Total Debt from the Company Balance Sheet: SGD 20,000,000

Shareholder Equity: SGD 5,000,000

Now, let's calculate the Debt-To-Equity Ratio for BrilliantTecQ Corp:

Debt-To-Equity Ratio = SGD 20,000,000 / SGD 5,000,000

Debt-To-Equity Ratio = 4:1

In this example, BrilliantTecQ Corp has a Debt-To-Equity Ratio of 4. This means that for every SGD 1 of shareholder equity, the company has SGD 4 in debt.

Now, let’s compare the two. 

ThousandTech Solutions has a relatively low D/E ratio of 0.5:1, indicating a conservative approach to financing. It relies more on its shareholders' equity to fund its operations and growth. This is often seen as a stable and financially sound approach, attractive to investors and lenders. In contrast, BrilliantTecQ Corp has a high Debt-To-Equity ratio of 4:1, suggesting a heavy reliance on debt financing. While this can potentially lead to higher returns, it also increases financial risk. The company might need help managing its debt and higher interest payments, making it a riskier proposition for investors and lenders.

Consequently, there’s a Long-Term Debt to Equity Ratio as well. 

What Is Long-Term Debt to Equity Ratio?

The Long-Term Debt to Equity Ratio gauges the balance between a company's long-term debt and shareholders' equity, calculated by dividing long-term debt by equity. A higher ratio signals increased reliance on long-term debt, indicating elevated financial risk. Conversely, a lower ratio points to a more conservative financial approach. 

How Is It Different From Debt to Equity Ratio?

The Long-Term Debt to Equity Ratio specifically considers the proportion of a company's long-term debt in relation to its shareholders' equity. It focuses on the portion of debt that has a maturity period exceeding one year. On the other hand, the Debt to Equity Ratio encompasses all forms of debt, both short-term and long-term, and assesses the relationship between the total debt and shareholders' equity.

When to Use the Debt-To-Equity Ratio?

The D/E ratio is a valuable financial metric for assessing a company's capital structure and financial leverage. Here are situations when it is beneficial:

  • Checking Health: It's like a quick checkup for a company. A low D/E ratio usually means the company is financially stable and not taking significant risks. But if it's high, it could mean more financial risk.
  • Risk Evaluation: A high Debt-To-Equity ratio may lead to higher interest payments and financial risk, especially when things get tough. A lower ratio is safer because it shows the company isn't relying heavily on debt.
  • Taking a Loan: If a company wants to borrow money, lenders look at the D/E ratio to decide if it's a good bet. A high Debt-To-Equity ratio can make it harder for a company to get loans or good loan terms.
  • Keeping an Eye: Watching how a company's D/E ratio changes over time can tell you if they're taking on more debt or being more cautious with their finances.
  • Compare: You can use this ratio to compare companies in the same industry. It's like seeing who's in better financial shape.
  • Smart Investments: This ratio can help you decide if you're considering investing. Lower ratios are often safer for cautious investors, while higher ones might bring more profit but also more risk.

Interpreting the Debt-To-Equity Ratio

Understanding the Debt-to-Equity (D/E) ratio is crucial for business owners, as it provides insights into your company's financial structure and potential risk. However, it's essential to recognise that the goal is only sometimes to achieve the lowest possible ratio.

What Is a Good Debt to Equity Ratio?

It can vary depending on your business and what it does. In general, if your D/E ratio is below 1, it's seen as safe. A low D/E ratio can indicate that your company is mature and has accumulated substantial capital over the years. While this may seem like a positive sign, it can also suggest that you're not optimising your resource allocation. In other words, you might be playing it too safe. It's vital to be careful while also taking advantage of chances to grow.

Remember that excessively cautious management sometimes results in a D/E ratio that doesn't sit well with minority shareholders, especially in publicly traded companies. These investors may expect higher returns on their investments. If your D/E ratio is too low, it could lead to dissatisfaction among minority shareholders who aspire to see more significant returns on their investments. But to answer the question – what is a good Debt-To-Equity Ratio, around 2 or 2.5 is often considered a strong position.

However, to achieve growth, you might need to borrow money to make the most of your resources. This strategy can help you and your shareholders achieve the desired returns. But it's important to know that if the total debt exceeds the extra money it brings, it can hurt your company's stock value. This can happen when the cost of repaying the debt and market conditions change. Borrowing money that seemed like an intelligent choice initially might not be profitable in different situations.

What Is a Bad Debt to Equity Ratio?

A bad debt-to-equity (D/E) ratio is when a company owes a lot more money than it owns. If the D/E ratio is really high, it can be a red flag, suggesting the company might have trouble paying back its debts. This could lead to problems like higher interest costs, making it tougher for the company to invest in new things or give returns to its investors. It's like having a big credit card bill without enough money saved up. While what's considered "bad" can depend on the type of business, having too much debt is generally seen as risky and might make it harder for the company to handle tough times.

Benefits of a High Debt-to-Equity Ratio

Firstly, the interest payments on debt are often tax-deductible, potentially reducing taxable income. Secondly, a higher D/E ratio allows you to leverage debt for expansion, acquisitions, or capital projects, accelerating growth without diluting ownership. Thirdly, if the returns generated from borrowed funds exceed the cost of debt, it can enhance your return on equity. Moreover, a high D/E ratio may signal confidence in your ability to handle debt, potentially influencing investors positively. Accessing debt financing at favourable interest rates, utilising assets efficiently, and contributing to share price appreciation are among the benefits of a carefully managed high D/E ratio. 

To sum it up, as a business owner, your choices about borrowing money should be well thought out. You need to think about both the possible advantages and the risks. Sound financial management means finding the sweet spot between using debt to grow your business and ensuring you can handle that debt in different situations.

Key Differences Between Debt-To-Equity Ratio & Other Available Ratios.

  1. Debt-To-Equity Ratio vs Gearing Ratio

The Debt-To-Equity Ratio compares a company's total debt to its shareholders' equity, encompassing both short-term debt and long-term debt and all types of equity. In contrast, the gearing ratio focuses solely on the long-term debt obligations of the company. Both ratios offer insights into a company's financial leverage. Still, their calculations and emphasis differ, with the Debt-To-Equity Ratio providing a broader view of financial structure and the gearing ratio honing in on long-term debt's role in funding operations and investments. 

While the Debt-To-Equity Ratio is calculated as Debt-To-Equity Ratio = Total Debt / Shareholder Equity, the Gearing Ratio is computed by the Gearing Ratio = Long-Term Debt / (Long-Term Debt + Equity).

The choice between these ratios depends on the specific financial analysis and context in which they are used.

After gearing ratio vs debt to equity, let’s look at debt to equity ratio vs debt to asset ratio.

  1. Debt-To-Equity Ratio vs Debt-To-Asset Ratio

While you already know what the Debt-To-Equity Ratio is, the Debt-to-Asset Ratio shows the part of a company's stuff (total assets) that is funded by debt. Its formula is Debt-to-Asset Ratio = Total Debt / Total Assets. So, one looks at money borrowed compared to what the owners have invested, while the other checks how much of a company's things are paid for by debt. 

  1. Debt-To-Equity Ratio vs Current Ratio

The Debt-To-Equity Ratio looks at the company's long-term money situation, comparing all its debts to the equity. It tells us if the company relies more on borrowed money or its own. Meanwhile, the Current Ratio checks if the company can pay its bills right now. It calculates the company's short-term liquidity by dividing its current assets by its total liabilities. So, one looks at long-term stuff, and the other tells us if it can handle short-term expenses. Both ratios help in different money situations.

  1. Debt-To-Equity Ratio vs ROE (Return on Equity)

As you know, the Debt-To-Equity Ratio checks how much a company borrowed compared to what the owners invested. The Return on Equity (ROE) measures how well the company makes money with the owners' investments. Its formula is ROE = Net Income / Shareholders' Equity. So, ROE shows how effectively the company uses that owner's money to make profits. Both these metrics help you understand different parts of a company's financial health and performance.

  1. Debt-To-Equity Ratio vs Debt Ratio

The D/E ratio and the Debt Ratio are tools to understand how a company uses debt, but they look at things differently. The D/E ratio compares a company's total debt to its total shareholder equity (ownership), telling you how much of its financing comes from debt compared to what it owns. On the other hand, the Debt Ratio looks at the total debt concerning all the company's assets, showing you the percentage of its stuff (like buildings, equipment, etc.) that's paid for with debt.

What Are the Limitations of the Debt-To-Equity Ratio?

If you run a business, it's good to know that the Debt-to-Equity Ratio has some limitations. Different industries have different needs for money and growth, so what's okay in one industry might be different. For instance, utility companies usually have high D/E ratios because they make steady money and must invest a lot. The Debt-to-Equity Ratio doesn't consider qualitative factors such as the company's business model, competitive advantage, or management's ability to handle debt. While it provides an overview of a company's financial leverage, it doesn't reveal the details of its debt structure, such as the types of debt, interest rates, or maturity dates.

Moreover, there needs to be more clarity about whether to count preferred stock as debt. Depending on how you do it, it can change how your D/E ratio looks. This is especially important in industries that use a lot of preferred stock, like real estate investment trusts (REITs). Besides, the ratio can change rapidly due to market conditions, capital structure changes, or significant financial events, making it less useful for real-time analysis. So, remember these things when you're checking your business finances.

Crucial Queries Regarding the Debt-To-Equity Ratio

  1. What does a high Debt-To-Equity Ratio mean?

When your business has a high Debt-To-Equity Ratio, you've borrowed a lot of money compared to what you and other owners have put in. It can make your business riskier because you have a bigger debt load. But remember, it's not always a problem – it depends on your industry and how well you can manage and repay that debt. So, consider your specific situation before deciding if it's a good or bad thing for your business.

  1. What does a negative Debt-To-Equity Ratio mean?

If your business has a negative D/E ratio, you owe more money than your company's assets are worth. In other words, your debts are greater than what your business owns. This is a risky situation because it could mean your business is in financial trouble. When your debts outweigh your assets, it can be hard to pay your bills, and you might need to consider taking steps to manage your debts or even consider legal protection to avoid financial collapse.

  1. Which industries usually have high debt-to-equity ratios? 

In the banking and financial services field, it's pretty standard to see high D/E ratios. Banks have many branches and buildings, which they buy using borrowed money, so their debt tends to be high. You'll also find higher D/E ratios in industries that need much cash to run, like airlines and companies that make things, like factories. They use debt to keep their operations going and growing. So, these industries often have higher debt compared to what they own.

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ABOUT THE AUTHOR
Aaron Oh is a seasoned content writer specialising in finance, insurance and tech industries. With a writing history at S&P Global, EdgeProp, Indeed, Prudential, and others, Aaron leverages finance knowledge and business insights to help businesses improve productivity and performance.
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Aspire is the all-in-one finance operating system for businesses. Our mission is to empower the next generation of entrepreneurs with the financial tools they need to realise their company’s full potential.
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