What is the debt to equity ratio and does it apply to all business? The short answer is that investors and creditors use it to see if a business is likely to pay back its debt and sustain a decline in sales. This applies to most business, but it is not relevant to companies that don’t have debt. These two issues determine if the company is vulnerable to changes in the business cycle. If it is highly leveraged – meaning a high proportion of debt financing – it is riskier.
Reasons for the Debt to Equity Ratio
One reason that investors look at this leverage ratio is to judge whether the company will always be able to service its loans. If your ability to continually pay off debt is questionable, this highly geared (highly leveraged) business is not worth the risk. High debt payments can absorb any free cash flow in a business and lead it to a halt.
Debt to Equity Formula
The debt to equity formula is total liabilities/equity. This is the simplest version of the equation and considers both long and short term debt. Other versions of the debt to equity formula are adjusted to show long term debt/equity. This can be useful for certain industries but you should also compare it to the original formula (total liabilities/equity).
One thing about the debt to equity formula is that it is only one ratio. It does not give an in-depth view of the company’s debts but simply makes it easy to tell if something is noticeably off. Companies can also distort this ratio in an attempt to make another ratio look better. One example of this is with return on equity. If a business wants to keep a very high return on equity, it will only accept a certain amount of equity. The rest of the required financing will be from debt, thus optimizing the effect of the equity investment.
How do you use the debt to equity formula in your business? For further reading about debt to equity ratios, check out this article.
If you want to add more value to your organization, then click here to download the Know Your Economics Worksheet.
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