What Is a Good Debt-To-Equity Ratio?

Financial analysts and investors are often very interested in analyzing financial statements in order to carry out financial ratio analysis to understand a companys economic health and to determine if an investment is considered worthwhile or not.

The debt-to-equity ratio (D/E) is a financial leverage ratio that is frequently calculated and looked at. It is considered to be a gearing ratio. Gearing ratios are financial ratios that compare the owners equity or capital to debt, or funds borrowed by the company

This ratio compares a companys total liabilities to its shareholder equity. It is widely considered one of the most important corporate valuation metrics because it highlights a companys dependence on borrowed funds and its ability to meet those financial obligations.

Because debt is inherently risky, lenders and investors tend to favor businesses with lower D/E ratios. For lenders, a low ratio means a lower risk of loan default. For shareholders, it means a decreased probability of bankruptcy in the event of an economic downturn. A company with a higher ratio than its industry average, therefore, may have difficulty securing additional funding from either source.

around 1 to 1.5

Understanding Debt to Equity Ratio

Why is a good debt-to-equity ratio important?

A good debt-to-equity ratio is important for a variety of reasons. In a business sense, analysts and investors use a companys debt-to-income ratio to determine how risky a potential investment would be. Therefore, if your business has a good debt-to-equity, theyre more apt to want to invest in your company. If youre an entrepreneur or small business owner, a good debt-to-equity ratio can help you get approved for a loan or help you establish a business line of credit.

When you have a good personal debt-to-equity ratio, youre more apt to qualify for loans as an individual or small business. This is because lenders use it to evaluate your ability to pay your loan payments in the future. For example, if you have more assets than debt, youll likely be able to continue making payments — even if you suddenly become out of a job for a few months.

What is a debt-to-equity ratio?

A debt-to-equity ratio is a companys debt or total liabilities divided by its shareholders equity. Its calculated using the following formula:

Debt-to-equity ratio = total liabilities / shareholders equity

A debt-to-equity ratio measures a companys financial leverage and health. This ratio allows you to determine your companys ability to cover its debts in the event of an economic or business downturn. Analysts use your debt-to-equity to determine whether or not your company would be a good investment for investors or lenders.

You can also use the debt-to-equity ratio for your personal finances. In this regard, youd divide your debt divided by your net worth.

What is equity?

Analysts use equity to evaluate a companys financial health. To calculate it, you need to subtract a companys total liabilities from its total assets. Keep in mind that a companys total liabilities represent all of its debt. This includes both its short- and long-term debt, as well as other liabilities.

What is debt?

Debt refers to the amount of money owed from a bank or lender. When you have a debt arrangement, a lender agrees to let you borrow a certain amount of funds under the condition that youll pay the money back by a certain date — usually with accrued interest. Typically, you pay off your debt at regular intervals until its paid off in its entirety. When you have a debt-to-equity ratio of zero, youre debt-free.

What is a good debt-to-equity ratio?

What constitutes a “good” debt-to-equity ratio depends on the company and the industry. Typically, its best to have a debt-to-equity ratio below 1.0, though, you should at least aim for below 2.0. As expected, the lower your debt-to-equity ratio, the better. When you have a low debt-to-equity ratio, your company has lower liabilities compared to its assets. You typically find this with long-running and successful companies.

What is a negative debt-to-equity ratio?

The higher your debt-to-equity ratio, the worse your financial situation is. Essentially, a high debt-to-equity ratio means your company is financed through debt rather than wholly-owned funds. While this is not necessarily a bad thing, a high ratio indicates higher financial risk. This financial risk may deter prospective investors, lenders, suppliers and partners.

When a company has a negative debt-to-equity ratio, it means it has negative equity. Essentially, it means it has more liabilities than assets. Typically, this presents a risk situation for your business as it can indicate that youre on the verge of bankruptcy. While it varies by industry, a poor debt-to-equity ratio is typically one above 2.0. If your company has a debt-to-equity ratio higher than 2.0, it means it borrows twice as much for funding than it really owns.

Examples of the debt-to-equity ratio

To help you better understand how the debt-to-equity ratio, consider the following examples:

Good debt-to-equity ratio

Lets say you have a clothing company thats applying for funding. To apply, you need to calculate your debt-to-equity ratio. Now, lets say you have a shareholders equity of $105,000 and total liabilities of $100,000. Using the debt-to-equity ratio, your calculation would be as follows:

Debt-to-equity ratio = total liabilities / shareholders equity

Debt-to-equity ratio = $100,000 / $105,000

Debt-to-equity ratio = 0.95

Therefore, you have a good debt-to-equity ratio of 0.95. With a debt-to-equity ratio of 0.95, lenders are more likely to invest in your business since your company isnt primarily funded through debt.

Poor debt-to-equity ratio

Lets say youre applying for funding for your record store. You have a shareholders equity of $125,000 and total liabilities of $300,000. Using the debt-to-equity ratio, your calculation would be as follows:

Debt-to-equity ratio = total liabilities / shareholders equity

Debt-to-equity ratio = $300,000 / $125,000

Debt-to-equity ratio = 2.4

Therefore, you have a debt-to-equity ratio of 2.4. With a debt-to-equity ratio of 2.4, lenders are less likely to invest in your company since its mainly funded with debt.

FAQ

Is a debt-to-equity ratio below 1 good?

A ratio greater than 1 implies that the majority of the assets are funded through debt. A ratio less than 1 implies that the assets are financed mainly through equity. A lower debt to equity ratio means the company primarily relies on wholly-owned funds to leverage its finances.

Is 0.4 debt-to-equity ratio good?

In general, many investors look for a company to have a debt ratio between 0.3 and 0.6. From a pure risk perspective, debt ratios of 0.4 or lower are considered better, while a debt ratio of 0.6 or higher makes it more difficult to borrow money.

Is it better to have a higher or lower debt-to-equity ratio?

Is a Higher or Lower Debt-to-Equity Ratio Better? In general, a lower D/E ratio is preferred as it indicates less debt on a company’s balance sheet.

Is a .5 debt-to-equity ratio good?

Generally, a good debt-to-equity ratio is anything lower than 1.0. A ratio of 2.0 or higher is usually considered risky.

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