The Debt-to-Equity ratio is a measure of a company’s financial leverage, and is computed by dividing Total Liabilities by Total Equity. The higher the number, the greater the financial leverage. What is financial leverage? Financial leverage has to do with the amount of return on investment that can be generated from a stated amount of equity. The greater the debt-to-equity ratio, the greater the leverage, and potentially the greater the return on investment.
For example, let’s say you bought a house for $1M and paid cash. If the house increased in value up to $1.1M, you would have made 10% on your equity investment of $1M. But if instead, you had only put down $100K and borrowed $900K when you bought the house, the $100K increase in value would represent a 100% return on your equity investment of $100K.
But leverage is a double-edged sword. It’s great when property or companies are increasing in value, but leave little margin when they decrease in value. If the value of the house drops below $900K, the owners equity would be wiped out, and the bank would be left holding the bag. This is why lenders don’t like to see large debt-to-equity ratios.
What a good debt-to-equity ratio is will depend on many factors. For example, public companies tend to have lower debt-to-equity ratios than do private companies. Many start-up companies, especially those that are high-tech, tend to have low debt-to-equity ratios due to high start-up costs that are usually funded by equity investors. Many established privately owned companies that have large receivable and payable balances will often have high debt-to-equity ratios, because the large payable balances will skew total liabilities.
If your bank has loan covenants that require that the debt-to-equity ratio not exceed a certain number, it’s imperative to have a financial model business plan that predicts the debt-to-equity ratio at future dates. For more information, visit our video library at www.CFOoutsource.com.