In the simplest terms, a debt-to-equity ratio expresses a company’s amount of outstanding obligations against the net value of the business.
Often viewed as an indication of the stability of a company, the ratio is calculated by dividing the total amount of liabilities a company has by the total amount of its shareholder equity.
Learn more about this concept so you can answer the question, “What is a good debt-to-equity ratio?”
What Is Debt?
Debt is money that an individual or an organization owes to an investor, lender or bank.
Debt generally results when a lender agrees to give a borrower the use of a certain amount of money over a specified period. In exchange, the borrower agrees to repay the money, along with a certain percentage of interest that serves as the lender’s profit on the investment.
Loan parameters vary in terms of the amount of time the borrower has to repay the funds, as well as the amount and frequency of interest charges that will be applied.
Some borrowers can get into trouble with their debt and may need to seek options such as debt relief to find a way out of their problems.
What Is Equity?
Equity is the total value of an organization held by its shareholders after its debt is subtracted.
One way to picture this is to ask how much money would be left to divide among all of the people with a stake in the business if the company was sold and all of its debts were paid off.
Equity can also be seen as a means of determining how well a business is doing. While it’s true that many organizations use debt to fund their operations, the goal is often to ensure the company is worth more than the debt outstanding against it.
This is where the debt-to-equity ratio comes in.
What Is a Debt-to-Equity Ratio?
A debt-to-equity ratio is the total amount of debt currently outstanding against a company, divided by the equity held by its shareholders.
The formula to calculate the ratio looks like this:
- Debt-to-equity ratio = Total liabilities / Shareholder’s equity
A company’s debt-to-equity ratio can give you a good idea of its ability to cover its liabilities in the event of an unexpected decrease in revenues. The ratio can also indicate the ability of a firm’s management team to invest in new opportunities.
Additionally, the debt-to-equity ratio can help outside investors decide whether or not infusing an organization with capital makes sense.
What’s a Good Debt-to-Equity Ratio?
So, what debt ratio is good? This can vary from industry to industry, as well as from company to company. That said, lower debt-to-equity ratios are often considered a sign of success.
Remember, a debt-to-equity ratio measures the amount of debt a company has relative to its worth. With that in mind, it becomes easier to understand what type of ratio is considered to be good.
Generally, a debt-to-equity figure of “one” or less is considered outstanding. Conversely, a debt-to-equity ratio greater than “two” usually results from financing the operations of a business with debt rather than revenue.
Granted, this latter situation isn’t always a bad thing, but it can indicate the company is on risky ground. This, in turn, can be a turnoff for potential investors, suppliers and partners.
After all, a high debt-to-equity ratio indicates a company might be unable to weather a series of unexpected financial setbacks.
Lowering a High Debt-to-Equity Ratio
Restructuring a company’s debt portfolio can sometimes result in a lower debt-to-equity ratio. This most often entails debt consolidation, which is debt refinancing that makes obligations easier to service.
Whatever strategy a company’s management team pursues in this regard, the goal should always be to ensure there is enough readily liquidated capital to handle unexpected financial downturns.
