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Debt to Equity Ratio

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25 / Jan / 2012

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10 financial concepts you should master

Here is lesson four in unwrapping essential financial concepts and how they will help you run your business.

Debt-to-equity ratio

This ratio tells you the portion of total assets that were financed by creditors, liabilities and debt versus the portion funded by owner’s equity. It is regarded as a tool that allows investors and financiers to measure how much money a company can safely borrow over long periods of time.

A debt to equity ratio divides total liabilities by the total shareholder capital (how much money shareholders) have invested in the business.

Let us say, for example, you bought $1 million worth of assets, putting in $500,000 of your own money and borrowing the balance.

You have $500,000 of debt and $500,000 of equity to buy the $1 million of assets. The ratio in that case is a relatively low 1:1.

A corporation with total liabilities of $1 million and shareholder equity of $500,000 will have a debt to equity ratio of 2:1.

Where the total liabilities are $1.2 million and shareholder equity is $400,000 the debt to equity ratio is 3:1.

A corporation with $200,000 of shareholder equity and $1.2 million of liabilities will have a debt to equity ratio of 6:1.

The higher the ratio of debt to equity the greater is the risk for the corporation’s creditors and its prospective creditors.

A high ratio might also suggest that the business has been very aggressive in its financing.

Most importantly, a high ratio tells us the company is a riskier proposition. It is an indicator of the amount of financial leverage of a company and of how much debt it is carrying. It tells us all about the proportion of the company’s assets provided by creditors versus owners.

There are ways to manage the ratio. Over time as you earn profit you will have retained earnings sitting within equity and that could be used to repay debt.

Debt to equity ratios have been falling in recent years because banks are being more conservative in their lending and businesses are looking to pay down debt rather than expand.

In Australia at the moment the average debt to equity ratio among small businesses is about 0.6, where they might have $600,000 of debt and $1 million of equity.

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