Businesses consider a variety of activities as they plan their goals. Each goal requires the company to invest money. Two options exist for companies to receive money to use when pursuing their goals. These include selling stock or borrowing money. The debt to equity ratio shares information regarding which methods the company uses to acquire funds. Revenue increases the company’s equity and decreases the debt to equity ratio. If the company’s revenue experiences growth, the company needs to take action in order to maintain the same debt to equity ratio.
Locate the total liabilities from the balance sheet. Locate the total stockholder equity from the balance sheet. Divide the total liabilities by the total stockholder equity. This calculates the debt to equity ratio.
Locate the previous year total revenue from the prior year income statement. Locate the current year total revenue from the current year income statement. Subtract the previous year total revenue from the current year total revenue. This calculates the dollar growth in revenue.
Read the income statement from the current year. Locate the gross profit and total revenue. Divide the gross profit by the total revenue. This calculates the gross profit percentage. Multiply the gross profit percentage by the dollar growth in revenue. This calculates the increase in equity.
Multiply the increase in equity by the original debt to equity ratio. Subtract the total liabilities from the balance sheet. Borrow this amount of money to keep the debt-equity ratio constant with revenue growth.
Many lenders and investors want to see that companies manage both their debt and equity responsibly. This requires the company to balance their level of debt and equity.
The ideal debt to equity ratio varies by industry and by company. Companies with high debt to equity ratios borrow more money to use in the business than they earn. These companies incur greater financing charges. Companies with low debt to equity ratios use their equity rather than borrowing. These companies risk tying up funds acquired through equity that could be earning a greater return.
Don’t use the result of any single financial ratio to make decisions. Financial ratios represent one tool to evaluate financial performance. Each tool only presents one aspect of the company’s performance. Use a variety of measures to evaluate the company’s total financial performance.