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What Is A Good Debt To Equity Ratio
Companies strive to have a good debt to equity ratio so they can use the right level of debt capital and equity to grow their business.
The debt to equity ratio is a simple but important ratio providing lenders, investors, and business stakeholders information about the company’s financial stability.
In essence, you can determine how much debt the company is using to finance its business operations in relation to equity capital.
The good debt to equity ratio will depend on the company, the nature of its business, its industry and other factors.
For example, manufacturing companies tend to have a much higher debt to equity ratio than consulting firms or technology companies.
Although there’s no specific ratio that is considered a good debt to equity ratio, it’s important to assess a company’s own debt/equity ratio over time, compare it to peers, and the industry.
In essence, debt to equity ratio between 1 and 1.5 is considered a good debt to equity ratio.
In other words, with a debt to equity ratio of 1, the company’s total liabilities are equal to its shareholders’ equity.
A 1.5 debt to equity ratio means that the company is using $1.50 of debt for every $1.00 of equity on its books.
What Is Debt To Equity Ratio
Debt to equity ratio is a measure of how much debt a company has taken to finance its business operations in relation to the amount of equity on its books.
The debt to equity ratio (or D/E) is a financial leverage ratio that is used by financial analysis, investors, and companies to assess a company’s financial health.
D/E is considered a “gearing” ratio as it’s a measure of a company’s equity to debt.
Calculating Debt/Equity Ratio
To calculate debt equity ratio, you can use the following formula:
Debt Equity Ratio = Total Liabilities / Shareholder’s Equity
You can get the company’s total liabilities and shareholder’s equity directly from its balance sheet.
You can also calculate shareholder’s equity by taking the company’s total assets and subtracting its total liabilities to get the total equity.
High Debt To Equity Ratio
A high debt to equity ratio indicates that the company is using more debt than equity to finance its business operations and growth.
In most cases, companies should not exceed a D/E ratio over 2 based on the general views of financial analysis and investors.
A debt equity ratio of 2 means that the company is funded 67% through debt and 33% through equity capital.
A company having more debt on its balance sheet will need to have a more consistent cash flow to be able to service its debt.
For investors and lenders, when the DE ratio is too high, they will consider the company to be riskier than another with less debt on its balance sheet to service.
Mature companies having consistent profits and cash flow could afford to have more debt on their books as they will have the necessary cash flow to pay for their debt.
On the other hand, startups and growing companies without predictable revenues may not be able to assume a high debt to equity ratio.
Low Debt To Equity Ratio
A low debt to equity ratio means that the company is not using debt to finance its business operations.
Having a very low debt to equity ratio may not be optimal for a company when financing its growth.
Having debt is not necessarily a bad thing especially when the cost of debt is much lower than the cost of equity.
When a company’s debt/equity ratio is zero or too low, the company may not be using its capital to maximize growth and profitability.
As a result, many investors consider that a company with a low debt equity ratio is not as attractive as a company that has utilized debt in a smart and efficient manner to scale its business.
Why Is A Good Debt-To-Equity Ratio Important
The debt to equity ratio is one of the most frequently calculated financial ratios as it provides a measure of how much debt a company is using to fund its business.
In other words, the D/E ratio allows you to see how much a company depends on debt compared to equity to run its business.
Knowing how much debt a company has on its balance sheet is important in assessing the overall risk of the company.
When a company takes on debt, it must then reimburse the capital along with interest in accordance with a certain debt payment schedule.
Will the company have enough cash to fund its business and meet its financial obligations?
Having a good D/E ratio will send a signal to financial analysts, lenders, and investors that the company is using the right amount of debt to fund its business and will have the financial means to service its debt.
Investors and lenders tend to prefer companies with good debt to equity ratio as they will be less prone to default on their loan or go out of business if the market conditions change significantly.
How Much Debt Is Suitable For A Business
Highly profitable companies know how to use debt capital and equity to fund their company’s operations and generate the most returns.
If a certain amount of debt is healthy for a company to take as you will take advantage of the power of leverage, but how much debt is suitable for a business?
In essence, taking the right amount of debt (leading to a good debt to equity ratio) is something that every company must carefully evaluate and determine for itself.
Although in general, debt to equity ratio of 1 to 1.5 is considered good, every company’s business and situation is different and the right level of debt will also be different.
Here are some questions that you should ask yourself when deciding on how much debt to take for your company:
- What is your current debt to equity ratio?
- How much revenue can you consistently count on to generate?
- What is your company’s cash flow?
- What is the debt equity ratio of your competitors?
- What is the debt equity ratio in your industry?
- Do you need to provide personal guarantees when taking a business debt?
- Will you be able to service your debt with rising interest rates?
- What is your risk tolerance?
- Can you service your debt if you assume the worst?
As you can see, deciding how much debt is suitable for a business requires a careful analysis of your business needs and your cash flow expectations going forward.
Example of A Good Debt To Equity Ratio
Let’s look at what is a good debt to equity ratio for a company by looking at an example.
Imagine that you have a software company and you have $500,000 in total debt on your balance sheet and shareholder’s equity of $400,000.
Your company’s D/E ratio is 1.25 ($500,000 / $400,000).
This is a pretty healthy D/E measure as it indicates that for every $1.00 of equity, you are using $1.25 of debt to fund your business.
However, imagine that you have $1,000,000 of debt and $400,000 of shareholder’s equity.
In this case, your D/E ratio comes out to 2.5.
For many lenders and investors, a 2.5 D/E ratio indicates that you are operating a riskier company as 71.4% of the funds you use to operate your business come from debt.
Lenders will wonder if you’ll have the cash flow to service your debt, they’ll compare you to other software companies to see what is their average D/E ratio, and they’ll probably lend you money at higher rates with many restrictive covenants.
What Is A Good Debt/Equity Ratio Takeaways
So there you have it folks!
What is a good debt ratio for a company?
What is a good debt to equity percentage in simple terms?
Debt to equity ratio (or D/E ratio) is a financial measurement between a company’s total debt and total equity.
Successful companies are mindful of how much debt they put on their balance sheet to avoid unnecessary financial cash flow strain on their business and to ensure they could repay the debt.
Since debt is inherently risky, investors and lenders consider that companies with too much debt on their books are riskier than others.
As a result, it’s important to ensure that you have a healthy amount of debt to fund the growth of your business without putting the company in financial jeopardy.
The debt-to-equity ratio can be calculated by taking a company’s total liabilities and dividing it by the total shareholder equity.
A good debt-to-equity ratio for most companies is between 1.0 and 1.5.
Being below 1.0 can suggest that you’re not efficiently making use of capital to maximize your business profitability whereas being above 2.0 suggests that you are risky as more than 2/3 of your capital funding comes from debt.
Determining the “good debt to equity ratio” is not an exact science and will depend on many factors.
The numbers I’ve presented to you should be considered as a guide helping you make decisions but you should consider what’s good specifically for your business by taking the unique characteristics of your business into consideration.
I hope I was able to help you answer the question of what is a good debt-to-equity ratio and why it’s important.
Good luck with your assessment!
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