Many times businesses take on lots of debt to help accelerate their revenue and generate more profits and in the end, become a bigger business.
Debt may seem fine when things are going a companies way, but if used excessively, it could spell potential danger, especially if things don't turn out the way a company expects them to.
To check if a company is handling debt well-- especially long term debt, we can make use of what is called the Debt to Equity Ratio.
The Debt to Equity Ratio is calculated by taking the Total Debt and dividing it by the Owners Equity.
The Formula for the Debt to Equity Ratio is
D/E = Total Debt / Owners Equity
The Total Debt and Owners Equity figures can be found in the Balance sheet of a firm.
Let's say Superpower Inc., a company manufacturing widgets, has $5M in overall debt and $10M in equity.
To calculate the Debt to Equity ratio, we take the $5M in debt and divide it by the $10M in equity and come up with the no — 0.5, which means that the company has 50 cents for each dollar in equity.
In most industries, a good debt to equity ratio would be under 1 or 1.5. However, this number varies depending on the industry as some industries use more debt financing than others.
For example, it is not uncommon for capital intensive industries like manufacturing to have higher ratios, which are above 2.
As a rule of thumb, the higher the number, the more loaded the company is with debt compared to owners equity and a high debt/equity ratio is often associated with high risk.
Borrowing too much costs money, increases risk and can place restrictions on management in the form of restrictive lender covenants governing what a company can and can't do, so, it's always better to have a low debt to equity ratio.
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