How To Check If You Have Debt – The debt-to-equity (D/E) ratio is used to assess a company’s financial leverage and is calculated by dividing a company’s total liabilities by its shareholders’ equity. The D/E ratio is an important metric in corporate finance. It is a measure of the extent to which a company finances its operations with debt rather than its own resources. The debt-to-equity ratio is a specific type of gearing ratio.
Debt/equity = Total liabilities Total equity begin &text = frac } } \ end Debt/equity = Total equity Total liabilities
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The information needed to calculate the D/E ratio can be found on the balance sheet of listed companies. Subtracting the value of the liabilities on the balance sheet from the total assets shown there gives the figure for equity, which is a rearranged version of this balance sheet equation:
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Assets = Liabilities + Shareholders’ Equity begin &text = text + text \ end Assets = Liabilities + Shareholders’ Equity
This category of the balance sheet may include items that are not normally considered debt or equity in the traditional sense of a loan or asset. Because the ratio can be distorted by retained earnings or losses, intangible assets and pension plan adjustments, further research is usually necessary to understand the extent to which a company relies on debt.
To get a clearer picture and facilitate comparison, analysts and investors will often change the D/E ratio. They also evaluate the D/E ratio in the context of short-term leverage ratios, profitability and expected growth.
Business owners use a variety of software to track D/E ratios and other financial metrics. Microsoft Excel provides a balance sheet template that automatically calculates financial ratios such as D/E ratio and debt ratio. Or you can enter values for total liabilities and equity in adjacent spreadsheet cells, say B2 and B3, then add the formula “=B2 / B3” in cell B4 to get the D/E ratio.
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The D/E ratio measures the amount of debt a company has taken on compared to the net asset value of its liabilities. Debt must be repaid or refinanced, incurs interest charges that cannot normally be deferred, and can affect or destroy the value of equity in the event of default. As a result, a high D/E ratio is often associated with high investment risk; this means that the company mainly relies on debt financing.
Debt-financed growth can increase earnings, and if the incremental increase in profits exceeds the associated increase in debt service costs, then shareholders should expect to benefit. However, if the additional cost of debt financing is greater than the additional income it generates, then the share price may fall. The cost of debt and a company’s ability to pay it can vary according to market conditions. As a result, borrowing which at first seems prudent may later become unprofitable in various circumstances.
Changes in long-term liabilities and assets tend to affect the D/E ratio the most because the numbers involved tend to be larger than short-term liabilities and short-term assets. When investors want to assess a company’s short-term leverage and its ability to meet debt obligations due in a year or less, they can use other ratios.
CashRatio = Cash + MarketableSecurities Short-Term Liabilities begin &text = frac + text } } \ end CashRatio = Cash Short-Term Liabilities + Marketable Securities
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CurrentRatio = Short-TermAssets Short-TermLiabilities begin &text = frac } } \ end CurrentRatio = Short-TermLiabilities Short-TermAssets
Let’s consider a historical example of Apple Inc. (AAPL). We can see below that for the fiscal year (FY) ending 2017, Apple had total liabilities of $241 billion (rounded) and total equity of $134 billion, according to the company’s 10-K statement.
Debt-to-equity = $ 241 , 000 , 000 $ 134 , 000 , 000 = 1.80 begin text = frac = 1.80 \ end Debt-to-equity = $134 , 000 , 0 $000 1 .
The result means that Apple has $1.80 of debt for every dollar of equity. But by itself, the ratio does not give investors the full picture. It is important to compare the ratio with other similar companies.
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Not all debts have the same risk. The long-term D/E ratio focuses on riskier long-term debt by using its value instead of the total liability in the numerator of the standard formula:
Short-term debt also increases a company’s leverage, of course, but because these liabilities must be paid in a year or less, they are not as risky. For example, imagine a company with $1 million in short-term debt (payroll, accounts payable, notes, etc.)-term. If both companies have $1.5 million in equity, then both have a D/E ratio of 1. On the surface, the risk of leverage is the same, but in reality the second company is riskier.
As a rule, short-term debt is cheaper than long-term debt and is less sensitive to changes in interest rates, meaning that the interest costs and capital costs of the latter are likely to be higher. If interest rates are higher when long-term debt comes due and needs to be refinanced, then interest costs will increase.
Finally, if we assume that the company will not default in the next year, then the debt due early should not be a concern. On the other hand, a company’s ability to pay off long-term debt will depend on its long-term business prospects, which are less certain.
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The D/E ratio can also be used on personal financial statements, serving as a personal D/E ratio. Here equity refers to the difference between the total value of individual assets and their aggregate debt, or liability. The formula for the personal D/E ratio is slightly different:
Debt/Equity = Total Personal Liabilities Personal Assets − Liabilities begin &text = frac } – text } \ end Debt/Equity = Personal Assets − Liabilities Total Personal Liabilities
Personal D/E ratios are often used when individuals or small businesses apply for loans. Lenders use the D/E figure to assess a loan applicant’s ability to continue making loan payments in the event of a temporary loss of income.
For example, prospective mortgage borrowers are more likely to continue making payments during longer periods of unemployment if they have more assets than debts. This also applies to individuals applying for a small business loan or line of credit. If a business owner has a good personal D/E ratio, it is more likely that they can continue to make loan payments until their debt-financed investment begins to pay off.
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Gear ratios form a broad category of financial ratios, of which the D/E ratio is the most well-known. “Gearing” is the term for financial leverage.
Gear ratios focus more on the concept of leverage than other ratios used in accounting or investment analysis. The basic principles generally assume that some leverage is good, but too much puts the organization at risk.
The debt-to-equity ratio is most useful when used to compare direct competitors. If a company’s D/E ratio is significantly higher than others in its industry, then its stock may be riskier.
When using the D/E ratio, it is very important to consider the industry in which the company operates. Because different industries have different capital requirements and growth rates, a typical D/E ratio value in one industry can be a red flag in another.
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Utility stocks often have very high D/E ratios. As a highly regulated industry that makes large investments usually with a fixed return and generates a fixed stream of income, utilities borrow heavily and relatively cheaply. A high leverage ratio in a slow-growing industry with stable earnings represents an efficient use of capital. Companies in the consumer staples industry have high D/E ratios for the same reason.
Analysts are not always consistent about what is defined as debt. For example, preferred stock is sometimes considered equity, because payment of preferred dividends is not a legal obligation and preferred stock is subordinate to all debts (but above common stock) in the priority of their claims on company assets. In contrast, the typically stable preferred dividends, par value and liquidation rights make preferred stock more like debt.
Including preferred stock in total debt will increase the D/E ratio and make the company riskier. Including preferred stock in the equity portion of the D/E ratio will increase the denominator and lower the ratio. This is an especially difficult problem when analyzing industries that rely primarily on preferred financing, such as real estate investment trusts (REITs).
What counts as a “good” debt-to-equity (D/E) ratio will depend on the nature of the company and its industry. In general, a D/E ratio below 1 will be seen as relatively safe, while a value of 2 or higher can be considered risky. Companies in some industries, such as utilities, consumer staples, and banking, typically have relatively high D/E ratios. Note that a very low D/E ratio can be negative, indicating that the company is not taking advantage of its debt financing and tax benefits. (Corporate tax expenses are usually tax deductible, while dividend payments are subject to corporate and personal income taxes.)
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