Investors and other financial analysts will often break down complex situations into much more manageable and simple representations. One of the most common places this happens is in the financial statements and analyses produced by those trying to understand or to give context to a company's economic or financial health. These simplified representations can often provide a significant amount of insight into the viability of a potential investment, and of these, one of the most common is the debt-to-equity ratio.
In most cases, a good debt-to-equity ratio is going to be any result of 1.0 or lower. Higher ratios do not exclude a particular company from attracting investors, although most investors will consider a debt-to-equity ratio of 2.0 or more to be relatively risky.
Since lending and, as a result, debt carries an inherent level of risk, investors or potential lenders will usually favor businesses with lower debt-to-equity ratios. This is because a lower debt-to-equity ratio often indicates that there are more assets available to pay down debts and possibly more frugal or prudent management of money. We're going to take a deeper look at just what the debt-to-equity ratio is & how it's calculated, what constitutes a good one, and how to improve it if it's not looking ideal.
How Do I Calculate My Debt-To-Equity Ratio?
In the simplest terms, the debt-to-equity ratio is calculated by dividing the total liabilities for a particular organization by the total shareholder equity. The formula can be written as:
Liabilities / Shareholders' Equity = Debt-To-Equity Ratio
The first step in calculating your debt-to-equity ratio is to gather, research, or otherwise calculate your company's total amount of liabilities and the full amount of shareholder equity. The most common location for these is on the balance sheets, and only the most current and complete data should be used in calculating the ratio. Future, potential, or speculative data should never be used for any practical debt-to-equity calculation purposes.
Once you have your data, you can simply plug the numbers into the formula to calculate your answer. As an example, if the company has total liabilities of $14 million, and total shareholder equity of $16 million, the resulting debt-to-equity ratio would be calculated as 0.875. With a debt-to-equity ratio of less than 1.0, this would represent a relatively good investment.
On the other side of the ratio, a company that has $5 million in liabilities and just $2.3 million in shareholders' equity would have a much different appearance to investors. With a debt-to-equity ratio of more than 2.1, this company would appear to have a much higher level of risk for potential investors.
What Is A Good Long-Term Debt-To-Equity Ratio?
Generally, the lower the debt-to-equity ratio is, the better. A lower debt-to-equity ratio indicates a lower level of debt on the balance sheet. While the debt-to-equity ratio is an easy and often accurate representation of the risk associated with lending to a particular company, the ratio may be more or less meaningful depending on the stage of growth of the organization, as well as their industry.
Newer companies and organizations will often use debt to stoke the fires of growth, taking on a higher debt-to-equity ratio for a few years to create self-sustaining business growth. Once the growth happens, there should theoretically be much more revenue, and the debt should decrease accordingly. This is important to keep in mind when discussing and calculating your debt-to-equity ratio, as they should always be weighed and considered in relation to the unique situation of the company.
Depending on the location of the organization, the view of the debt-to-equity ratio can vary wildly. In the US, debt-to-equity ratios of 1.0 or lower are considered to be good and representative of lower risk potential, while a debt-to-equity ratio of 2.0 or more would be seen as considerably riskier for lenders. However, Canadian businesses and lenders, for example, often view debt-to-equity ratios of 2.0 or even 2.5 to be relatively good.
Similar post: How Much Do You Have to Be In Debt to File Chapter 7?
What Is A Good Debt-To-Equity Ratio For Personal?
Your personal debt-to-equity ratio is often referred to as your debt-to-asset ratio, and it can be a helpful tool in evaluating if someone is over-leveraged or otherwise in a potentially sticky financial situation such as insolvency. This ratio is often considered as one of the primary factors in assessing an individual's ability to pay back funds loaned to them. Consumers that have borrowed funds that have overextended them beyond their ability to meet their financial obligations should not, and often are restricted from, taking out further financial liabilities like loans or lines of credit.
The debt-to-asset ratio for an individual is calculated similarly to the debt-to-equity ratio for a business. The total sum of the individual's liabilities is divided by the sum of total assets belonging to the individual. The formula for this is written as:
Total Liabilities / Total Assets = Debt-To-Asset Ratio
Some of the most common liabilities will include auto loans, mortgage, personal loans, credit cards, home equity line of credit, payday loans, title loans, and any other credit or borrowed funds. For those that rent, unfortunately, the models used for creating ratios like these are often unbalanced with regard to consumers to rent instead of own and can make the individual's debt-to-asset ratio look less favorable in some situations.
Total assets will include all funds and property that the individual owns. This is everything from cash and jewelry to investments, vehicles, land & real estate, computers, cryptocurrency, and any other property of value owned by the individual. All assets must be included, or the result can be more indicative of a liquid assets coverage ratio, which, while useful in some situations, isn't used in the same situations as a debt-to-asset ratio.
The general consensus is that a personal finance debt-to-asset ratio of 0.5 or less is ideal, with 0.8 as the absolute maximum where further credit is often denied. This means for every dollar in assets you have; you shouldn't have more than 50 cents of debt in an ideal situation. In a more practical example, if you have $100,000 in assets, you should have total liabilities of $50,000 or less, and any more would be considered over-borrowed in most considerations for credit or lending.
What Are Some Tips To Improve My Debt-To-Equity Ratio?
The first and arguably most important step of improving your debt-to-equity ratio is to understand all of your liabilities and debt. Not only understanding how much is owed but then taking actionable steps to swing the ratio in your favor. If your debt-to-equity ratio is lopsided, you may find it increasingly difficult to obtain new lines of revolving credit or get loans for large projects or emergencies if needed.
For individuals, having a less than ideal debt-to-equity ratio can mean getting a credit card or car loan is much more difficult or comes with much less favorable terms. It may prevent you from getting decent terms on a home loan or stop you from getting a lending offer at all in some cases. It can prevent you from renting an apartment and can even prevent you from being considered for certain employment opportunities.
The biggest hurdle for many people is simply keeping track of all their individual debts, large and small. The amount of debt most people have is often more than they think, and you can't work to clear it if you don't know it's there. Comb through all your records, and record all the information you can about your current balances with various creditors. Find all your credit accounts, car loans, mortgage documents, payday loans, and anything else you can find, even old debts that have been sent to collections.
Once you have all your information, you'll need to make a plan to pay down some or all of the debt. There are many different ways to go about this, and each method will have its pros and cons. Some people start with the smallest debt, and work their way up, often called the avalanche method. Others may target the debt that carries the highest interest rate, reducing the amount paid over longer periods.
Once you have started your debt reduction and debt-to-equity ratio improvement efforts, you must keep them up. This is particularly important if you have made any payment arrangements or debt settlement programs that require you to pay according to set terms or risk default. In some cases, you may be able to benefit from a debt consolidation loan, which can stop high-interest debt from continuing to grow, and simultaneously satisfy any payment arrangement needs quickly. This can let you pay one single loan, often with a far lower APR, while working with just one lender or creditor.
Maintaining A Good Debt-To-Equity Ratio
Now that you know what a good debt-to-equity ratio is, it's easier to set attainable goals for yourself or your business. Once you reach your debt-to-equity ratio goals, make sure the effort to maintain that ratio doesn't wane so that you can enjoy that better ratio long into the future.
More like this:
- Here's How to Calculate Bad Debt Expense [FORMULA EXPLAINED]
- How to Get a Loan With High Debt-To-Income Ratio? [ANSWERED]
- Debt To Income Ratio For Car Loan
Shawn Manaher is a former financial advisor, has founded 5 online businesses, and is a coach, speaker, podcast host, and author. He's been featured on Forbes, The Consults Corner on TAE Radio, The Writing Biz, What's Your Story, and more.