Every business uses a certain amount of short-term liabilities and long-term debt plus its stockholders’ equity capital to finance its operations. The amount of debt that a company has in proportion to the amount of its equity capital is the company’s financial leverage, which can indicate the state of its financial health.
The degree to which a company is leveraged is determined by the calculation of its debt-to-equity ratio. The questions remain, how much debt should a company have and what is a good debt-to-equity ratio?
What Is the Debt-to-Equity Ratio?
The debt-to-equity ratio is a metric calculated by dividing the amount of a company's total liabilities by its total shareholders’ equity, which includes common and preferred stock. It indicates the extent to which business owners are using debt instead of their equity capital base to finance the company’s operations.
Average debt-to-equity ratios vary by industry. A debt/equity ratio that is considered normal for one industry might be viewed as excessive in another.
What Is the Debt-to-Equity Ratio Formula?
To find a company's debt-to-equity ratio, you take its total debts and divide by its total equity capitalization, explains Ohio University. The formula is:
Debt-to-Equity Ratio = Total Debt Obligations/Total Equity
For example, suppose Company ABC had short-term debts, including accounts payable and other current liabilities, of $300,000, long-term debts of $500,000 and equity capital of $800,000. Its debt-to-equity ratio would be:
($300,000 + $500,000)/ $800,000 = 1
Company ABC has a debt-to-equity ratio of 1:1, meaning that the company has $1 in total debt for each $1 in equity capitalization.
The numbers needed to calculate the debt/equity ratio can be found on the company’s balance sheet.
What Is the Long-Term Debt-to-Equity Ratio?
The long-term debt-to-equity ratio is a variation of the overall debt/equity financial ratio. The long-term ratio only considers a company’s long-term debt in proportion to its equity capital. Investors and analysts calculate this ratio separately because they consider long-term liabilities as riskier than short-term debt.
Long-term debt is used to finance long-term assets, such as machinery or vehicles, and comes with fixed schedules for repayment and firm maturity dates. Businesses that are capital intensive and require large amounts of fixed assets, such as machinery and buildings, tend to have higher long-term debt/equity ratios because they finance these assets with long-term debt.
What Is a Good Debt-to-Equity Ratio?
In general, a comfortable debt-equity ratio is from 2:1 to 1:1. Michigan State University notes that lenders consider a high debt-to-equity ratio as a higher financial risk. On the other hand, a low debt-to-equity ratio, such as less than 1:1, may indicate that the company is not taking full advantage of its debt-borrowing capacity to take on more debt financing to improve its return on equity performance.
Using debt to finance growth may increase earnings if the incremental rise in profits is in excess of the interest expense to service the additional debt. In this case, the shareholders will benefit with a higher return on their equity investment.
However, a debt/equity ratio that seems appropriate at one time may become a problem if market conditions change in the future. For example, if interest rates rise and the company is forced to refinance its short-term and long-term debts at higher interest costs, this could have a negative effect on the company's cash flow and profit margins.
The mix of short-term debt versus long-term debt is also a factor. Most of the time, short-term interest rates will be lower than long-term rates, but in certain economic times, short-term rates could increase dramatically and affect the company's profits. In these cases, even a low debt-equity ratio may not be enough to absorb the impact of adverse economic conditions.
James Woodruff has been a management consultant to more than 1,000 small businesses. As a senior management consultant and owner, he used his technical expertise to conduct an analysis of a company's operational, financial and business management issues. James has been writing business and finance related topics for work.chron, bizfluent.com, smallbusiness.chron.com and e-commerce websites since 2007. He graduated from Georgia Tech with a Bachelor of Mechanical Engineering and received an MBA from Columbia University.