When looking at financial reports, one of the measures that experienced investors consider about any company is the debt to equity ratio. However, what exactly is it?
In simple terms, this number calculates as follows:
Debt to Equity Ratio = Total Liabilities / Shareholder’s Equity
In some cases, the financial reports may use a slightly different calculation:
Debt to Equity Ratio = Long-Term Debt / Shareholder’s Equity
The reason for taking this calculation is to measure how much of the company’s equity is leveraged for debt. The higher this ratio number, the higher the amount of leveraged equity exists. And, in general, the higher the amount of leveraged equity the more likely the chance is of a company having liquidity problems. On the other hand, having too low a debt to equity ratio can mean the company is not leveraging its equity enough. That can slow growth and indicate a lack of management focus.
Debt is not a bad thing for companies. It can offer chances to expand in new directions. It offers the ability to increase shareholder returns also. Smart use of debt is a great opportunity for a company to remain healthy. However, during times of financial crisis, too much debt can cause problems in meeting debt payments and can bring a company into the red zone. Managing debt amounts is important for any company, large or small. Smart management means growth. Poor management can mean bankruptcy.
When looking at the debt-to-equity ratio, you also need to take your comfort level for risk into consideration. A higher than average ratio means a bit more risk is involved with investing in a particular company. Much higher than average ratios present much higher risk.
Understand it from the other side of the equation. When you go out and get a mortgage, your debt to equity ratio makes a big difference in whether a company is willing to give you a mortgage or not. If you already have a great deal of debt, the company may not want to give you a mortgage due to the high level of risk you present. If the mortgage company will give you a mortgage, it may be at a high interest rate in order to cover the risk you present. You pay that price when you carry a great deal of debt without much equity in your assets. A company pays the price when they try to get investors.