Debt-to-Equity ratio is calculated by dividing total debt by total shareholder's equity (or total equity).
Here’s the formula for Debt-to-Equity Ratio :
Debt-to-Equity ratio = Total Debt / Total Equity
The D/E ratio is measured as a coefficient or multiples. Generally speaking, a ratio of less than 1 represents a company with more equity than debt or low leverage, while a D/E ratio higher than 1 means the company is using debt to finance more of its operations or a higher degree of leverage.
In proportion to other companies of its size and industry, that ratio varies significantly. A good debt to equity ratio is one that would be lower than the industry average. It is believed that companies with a debt to equity ratio less than 1.5 might be considered as having a good risk profile.
Companies can reduce their debt-to-equity ratio by either increasing its equity through new stock offerings, or by repaying or refinancing existing debt.
The goal of reducing debt by issuing equity is to bring the Debt-to-Equity Ratio down and to limiting borrowing costs associated with leverage. It should, however, be noted that additional equity issues dilutes existing shareholders' value. This means that equity external financing might only be attractive from a cost perspective in the presence of tax shields or when the company must grow to create value.
Ultimately, it is important to keep in mind that any decision should be weighed carefully with a cost-benefit analysis of building financial flexibility and a healthy debt-to-equity ratio at the forefront.
Debt ratios are important measures of a company's financial health and there are a few different ratios that can be used to measure the level of debt of a company:
- The Debt-to-Equity Ratio (D/E) = measures the total debt to total equity in a company.
- The Current Ratio compares a company's current assets to its current liabilities. This shows its ability to meet short-term obligations.
- The Quick Ratio compares a company's liquid or near liquid assets to its current liabilities. This indicates its ability to cover short-term obligations without relying on inventory.
- The Debt-to-Asset Ratio (D/A) calculates how much debt will be required to pay for a company's purchase obligations.
The Current and Quick Ratios show the liquidity of a business, and measure how much debt is required to pay its obligations. Certain industries may utilize different ratios due to their unique dynamics, such as the banking industry which will focus on liquid assets.
An increasing Debt-to-Equity Ratio often means that a company is taking on more debt relative to the amount of equity available. This means that the company is becoming increasingly reliant on debt financing to finance or grow its operations. An increasing Debt-to-Equity Ratio can also mean that the company is making poor decisions or is mismanaging its capital. Companies with increasing Debt-to-Equity Ratios should evaluate their ability to pay off the additional debt, and consider other alternatives such as issuing more equity or increasing profits in order to cover its obligations.