The sound of debt generally makes us think of high interest rates, bills, bankruptcy, or avoiding credit cards. However, when you have smart business know-how, the sound of debt isn’t that bad. Rather, the business analyst and investors offer to be such an opportunist to use debt smartly to grow the value of your business.
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This is exactly where the Debt-equity ratio errands the limelight in business. In this post, we will cover:
- What is the Debt-equity ratio?
- How To Calculate the D/E Ratio?
- Limitations of Debt To Equity Ratio
- Personal Finances and D/E Ratio
What is the Debt-To-equity ratio?
When a company’s total liabilities are divided by the shareholder’s equity, that is what we call the debt-to-equity ratio. These figures are generally included in the balance sheet of the business financial statement.
How To Calculate the D/E Ratio?
In the case of Sole Proprietorship, the D/E Ratio is calculated by dividing the debts of the business by the investment of the owner. Otherwise, it is calculated by dividing the business debts by the shareholder’s equity.
Here is the short Formula:
D/E Ratio = Total Business Debts / Shareholder’s Equity
Here is the Long Formula:
D/E Ratio = ( short term debts + long term debts + fixed payments ) / Shareholder’s Equity
Total debts of the business and shareholder’s equity are two main components. The balance sheet already has the details of shareholder’s equity, what needs to be worked on is total business debts. The name itself depicts the method of calculation.
Total Business Debts = Short-term debts + Long term debts
Limitations:
The industry in which your company is breathing is very important to consider while using the Debt to Equity Ratio. This is because the capital needs and the growth rates vary depending upon the type of industry your business belongs to.
There could be a high D/E ratio in a certain industry, while a comparatively low D/E ratio in another industry.
Personal Finances and D/E Ratio:
Personal Debt to Equity Ratio is when D/E Ratio can be applied to the personal financial statement. In such cases, equity is defined as the difference between an individual’s personal assets value and his liabilities or debts. The formula of the personal debt-to-equity ratio is:
Debt/Equity = Total Personal Liabilities/Personal Assets
Here personal debt, liabilities, and personal assets are prominent components. By personal debt, we mean the loan taken by the individual or the small business.
The lenders usually evaluate D/E to have an idea of how capable is the person to carry on with the loan episodes if his income stops for a temporary time period.
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Conclusion:
The concept of this ratio is important as it is helpful to indicate the financial health of a company by analyzing the aspects of owned and borrowed capital. In some cases, the D/E Ratio can be misleading if handled in the wrong manner.
It depends so much on the industry that your business belongs to. Since some companies are heavily capital intensive while others are low this changes the highs and lows of the D/E Ratio as well.
