What is debt to equity ratio?
The debt to equity ratio, also known as risk ratio, is a calculation used to appraise a company’s financial leverage based on its shareholder equity. It measures how much a company is financing its activities through debt rather than owned cash, and whether a business would be able to cover its debts with shareholder equity if there was a sudden downturn or other financial shock.
This makes it different to the debt-assets ratio which uses a business’s total assets as a denominator, and instead highlights how a company’s finances are balanced between debt and equity financing.
Key takeaways from this section:
- The debt to equity ratio shows a company’s financial leverage by comparing its total liabilities to its shareholder equity.
- A high debt to equity ratio can show a higher risk to investors and shareholders.
- Debt to equity ratios can look very different across different industries and types of business, so aren’t always easy to compare
Understanding debt to equity ratio
A company’s debt to equity ratio broadly tells you how a company is using debt as a means of leveraging its assets. If a business has a high debt to equity ratio it can often be a sign of high risk, as it shows a company is aggressively borrowing in order to fuel growth or run its operations.
The potential risk it demonstrates is of significant interest to investors, as naturally the outcome relies on a business being able to generate more earnings from growth than the debt costs to fund it. If the plan pays off, shareholders and investors can profit, but if the debt and interest completely swallow any profits, it can cause shares to take a nosedive and put the company’s financial stability at risk. This is why the debt to equity ratio can be such an important metric.
In general, the debt to equity ratio is used to evaluate long-term leverage, as changes in long-term debt tend to have the biggest effect on this metric. There are other ratios that can be better suited to evaluating a company’s short-term leverage, such as the cash ratio or current ratio.
How to calculate debt to equity ratio
To calculate the debt to equity ratio, you simply divide a company’s total liabilities by the total shareholder equity.
A company’s liabilities are the money it owes to other parties. This includes short-term liabilities such as wages to staff, bills for suppliers, interest on debts, utilities, and long-term liabilities such as debts that are due in more than a year. There are also elements that can skew the accuracy of the ratio, such as items on the balance sheet that don’t necessarily fit into debt or equity, such as retained earnings or losses, or intangible assets, so more research would be needed or adjustments made to get a more useful and accurate debt to equity ratio. This can sometimes be done by including elements like growth expectations or profit performance.
The debt to equity ratio in practice
When using the debt to equity ratio to appraise a company’s financial leverage, it’s important to put it into an industry context. A normal ratio can look very different across various industries and types of business, due to different growth rates, capital needs, and other factors.
Companies that produce everyday consumer products tend to have high debt to equity ratios because they usually have a stable and reliable income and therefore borrow money cheaply. Likewise, utility providers can also command stable income streams and grow slowly over time, commonly giving them a high debt to equity ratio.
Compound interest FAQ's
What is a good debt to equity ratio?
This will look different for different types of businesses, but a debt to equity ratio below 1.0 could broadly be seen as safe, while a ratio above 2.0 would represent a risk. A high ratio can be considered normal for many types of businesses, however, and a low ratio could even indicate a lack of expansion and growth.
What industries have high debt to equity ratio?
Businesses that produce essential consumer products tend to have high debt to equity ratios as they have reliable income and can borrow cheaply to fuel growth. The banking sector also tends to show a lot of high debt to equity ratios as banks naturally take on a lot more debt. Industries that require regular use of large amounts of capital may also show high ratios, such as manufacturers or the airline industry.
What does a high debt to equity ratio mean?
A high debt to equity ratio can show that a company has a larger amount of liabilities than shareholder equity, perhaps due to taking on a large amount of debt to fuel an expansion, or because of a heavy investment in new equipment or staff. What this means for the financial health of a company will depend on the nature of the business and the industry in which they operate, as it’s natural for some types of business to have a high debt to equity ratio.
Have you thought about Invoice Finance as a cash flow solution for your business?
Invoice finance allows you to release cash quickly from your unpaid invoices.
As your lender, we can release up to 90% of your invoices within 24 hours. On payment of the invoice from your customers, we will then release the final amount minus any fees and charges. There are different types of invoice financing options available to businesses depending on the situation and the level of control they require in collecting unpaid invoices.
We are an invoice financing company who offer a solution whereby payments are collected on your behalf managed by our team of expert credit controllers so you can focus on running your business. Our Confidential Invoice Discounting solution is offered to businesses who want to maintain their own credit control processes, therefore this remains strictly confidential so your customers are unaware of our involvement.
The benefits of invoice finance companies such as Novuna Business cash flow
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Competent staff, slick technology. Would recommend
Halo is one of the smartest bits of tech I have seen & every team is only as good a it's people and I would like to take this time to actually specifically point out Alex Hall & Claire Davies. Alex is an account manager that has continually improved during our time working together and is a real credit to Novuna. Claire has been exceptional from start to finish; meticulous in her work and very patient with us at every temp - an absolute star. It is a shame that the email address went to a generic platform and not each individual. I totally understand why this works better for companies but it did mean that the personal element was lost meaning that starts like Claire will be harder to identify from a customer point of view.
High recommedation for Novuna Business Cashflow.
My company was in need of invoice factoring to assist with the cashflow due to the nature of debtor days with our clients. After looking at a number of options, the right decision was made to work in partnership with Novuna Business Cashflow. Right from setup through sales to customer service, the communication and support has been outstanding. Providing me with all the information I needed regarding new clients coming onto our books. The system they use is so user friendly and the drawdown payments are very efficient in the fast moving world of temporary payroll. This has allowed my company to look at positive growth knowing we are safe financial hands. I would highly recommend Novuna Business Cashflow 10/10.
Set up went well and communication was good.
Syed and Vipul were extremely helpful top class service
Very helpful from the start
Great people made this process very straightforward.
Jemma from Novuna (formally Hitachi) was brilliant. Worked with us throughout the process and succeeded when some others had failed. Carried out the necessary checks with a smile and cheery demeanour, making what would have been a laborious process quite manageable.
Teething problems -Maybe ?
It's still early days so I may alter this review at a later date. However with retentions and concentration limits and other items, were finding were not getting 85% up front, were probably getting nearer 70% Also when a customer pays the remaining allegedly 15% due to us seems not to be credited to become available. For instance a customer paid Â£6918 and a customer paid Â£1300 hence we should see an extra Â£1330 available (15% of both these payments). However availability seemed to go down and not up by Â£1330 !!! Hard to work out where this 15% has actually gone ? I'll re-submit this review when things become clearer.
I found Hitachi true to their world in every aspect of the service they promised. I can't recommend enough.
Excellent Customer care and service.
Excellent customer service from start of initial conversations, right through to finally becoming a customer. The whole team involved are a credit to Hitachi, they were accommodating and informative the whole way along the process. I would highly recommend Hitachi to future clients and business associates. Thanks Alan.
I really enjoyed working with the Hitachi team, professional, helpful and really good people to deal with. They have made what could have been a very difficult experience a pleasure. Very happy to recommend them.
Hitachi made the process of moving factoring facilities painless, bearing in mind we previously had our facility with the same provider since 1997. I cant fault Hitachi's staff and processes and we are delighted with the move.
Staff excellent all together professional
Great service so far
From start to finish the process for transferring our invoice finance to Hitachi has been been brilliant, a smooth transition, great communication our link Person Jonathan Oakes has helped the process go through seamlessly, A great experience so far and a brilliant start to what we hope will be a long term partnership.