The debt to equity ratio definition is an indication of management’s reliance to finance its asset on debt rather than on equity. It measures a company’s capacity to repay its creditors. This ratio varies with different industry and company. Comparing the ratio with industry peers is a better benchmark.
The debt ratio means an indication of the gearing level of a company. A high ratio means that a company may be over-leveraged with debt. This can result in high insolvent risk since excessive debt can lead to a heavy debt repayment burden. However, when a company chooses to rely largely on equity, they may lose the tax reduction benefit of interest payments. In a word, a company must consider both risk and tax issues to get an optimal debt to equity ratio explanation that suits their needs.
Equity will include goods and property your business owns, plus any claims it has against other entities.
Debt to equity = 10,000 / 40,000 = 0.25
For example, Shari has started a residential real estate company which has grown to success. Though the market is tough, Shari has protected her cash account in order to deal with what the future holds. Shari now needs to perform debt to equity analysis to make sure she has not become over-leveraged in her company. This could cause problems with bank loans, her company free cash flow, and more.
Debt to equity = $10,000 / $40,000 = $0.25
Her controller finds that she is in perfect standing. Her company, though near its limit, does not have too much debt. It has enough cash to survive common issues which face the residential real estate industry.
She is satisfied that she has followed the path of a responsible business owner. Because she is so used to putting out fires, she is content with the status quo of her company’s regular monthly profits. Shari looks forward to her next quarter.
If you want to add more value to your organization, then click here to download the Know Your Economics Worksheet.
[box]Strategic CFO Lab Member Extra
Access your Strategic Pricing Model Execution Plan in SCFO Lab. The step-by-step plan to set your prices to maximize profits.
Click here to access your Execution Plan. Not a Lab Member?
Click here to learn more about SCFO Labs[/box]