What happens when debt-to-equity ratio increases?

The debt to equity ratio is a financial, liquidity ratio that compares a company’s total debt to total equity. The debt to equity ratio shows the percentage of company financing that comes from creditors and investors. A higher debt to equity ratio indicates that more creditor financing (bank loans) is used than investor financing (shareholders).

Formula

The debt to equity ratio is calculated by dividing total liabilities by total equity. The debt to equity ratio is considered a balance sheet ratio because all of the elements are reported on the balance sheet.

Analysis

Each industry has different debt to equity ratio benchmarks, as some industries tend to use more debt financing than others. A debt ratio of .5 means that there are half as many liabilities than there is equity. In other words, the assets of the company are funded 2-to-1 by investors to creditors. This means that investors own 66.6 cents of every dollar of company assets while creditors only own 33.3 cents on the dollar.

A debt to equity ratio of 1 would mean that investors and creditors have an equal stake in the business assets.

A lower debt to equity ratio usually implies a more financially stable business. Companies with a higher debt to equity ratio are considered more risky to creditors and investors than companies with a lower ratio. Unlike equity financing, debt must be repaid to the lender. Since debt financing also requires debt servicing or regular interest payments, debt can be a far more expensive form of financing than equity financing. Companies leveraging large amounts of debt might not be able to make the payments.

Creditors view a higher debt to equity ratio as risky because it shows that the investors haven’t funded the operations as much as creditors have. In other words, investors don’t have as much skin in the game as the creditors do. This could mean that investors don’t want to fund the business operations because the company isn’t performing well. Lack of performance might also be the reason why the company is seeking out extra debt financing.

Example

Assume a company has $100,000 of bank lines of credit and a $500,000 mortgage on its property. The shareholders of the company have invested $1.2 million. Here is how you calculate the debt to equity ratio.

When examining the health of your business, it's critical to take a long, hard look at your debt-to-equity ratio. If your ratios are increasing--meaning there's more debt in relation to equity--your company is being financed by creditors rather than by internal positive cash flow, which may be a dangerous trend.

You can avoid growing yourself out of business by sticking to your affordable growth rate. Your affordable growth rate is tied to your firm's assets. The basic idea is that your sales shouldn't grow more quickly than your assets. As a rule, this means if your sales double, your assets--including inventory, receivables and fixed assets--should also double. Assets are important because your lender may be unwilling to loan you any more money if your debt-to-equity ratio exceeds a certain figure. If sales and assets grow at the same rate, your debt-to-equity ratio should remain within the lender's limit, allowing you to borrow to finance growth forever.

The debt-to-equity (D/E) ratio is a metric that provides insight into a company's use of debt. In general, a company with a high D/E ratio is considered a higher risk to lenders and investors because it suggests that the company is financing a significant amount of its potential growth through borrowing. What is considered a high ratio can depend on a variety of factors, including the company's industry.

• The debt-to-equity (D/E) ratio reflects a company's debt status.
• A high D/E ratio is considered risky for lenders and investors because it suggests that the company is financing a significant amount of its potential growth through borrowing.
• Whether a D/E ratio is high or not depends on many factors, such as the company's industry.

The D/E ratio relates the amount of a firm’s debt financing to its equity. To calculate the D/E ratio, divide a firm's total liabilities by its total shareholder equity—both items are found on a company's balance sheet. The company’s capital structure is the driver of the debt-to-equity ratio. The more debt a company uses, the higher the debt-to-equity ratio will be.

Debt typically has a lower cost of capital compared to equity, mainly because of its seniority in the case of liquidation. Thus, many companies may prefer to use debt over equity for capital financing. In some cases, the debt-to-equity calculation may be limited to include only short-term and long-term debt. Most often, it also includes some form of additional fixed payments. Together, the total debt and total equity of a company combine to equal its total capital, which is also accounted for as total assets.

As is typical in financial analysis, a single ratio, or a line item, is not viewed in isolation. Therefore, the D/E ratio is typically considered along with a few other variables. One of the main starting points for analyzing a D/E ratio is to compare it to other company's D/E ratios in the same industry. Overall, D/E ratios will differ depending on the industry because some industries tend to use more debt financing than others. In the financial industry, for example, the D/E ratio tends to be higher than in other sectors because banks and other financial institutions borrow money to lend money, which can result in a higher level of debt.

Other industries that tend to have large capital project investments also tend to be characterized by higher D/E ratios. These industries can include utilities, transportation, and energy.

A popular variable for consideration when analyzing a company’s D/E ratio is its own historical average. A company may be at or below the industry average but above its own historical average, which can be a cause for concern. In this case, it is important to analyze the company’s current situation and the reasons for the additional debt.

The weighted average cost of capital (WACC) can provide insight into the variability of a company’s D/E ratio. The WACC shows the amount of interest financing on the average per dollar of capital. The equation also breaks down the average payout for debt and equity.

If a company has a low average debt payout, this implies that the company is obtaining financing in the market at a relatively low rate of interest. This advantage can make the use of debt more attractive, even if the D/E ratio is higher than comparable companies.

A debt-to-equity ratio measures the amount of debt a company uses to fund its business for every dollar of equity it has. The debt-to-equity ratio formula is: Total liabilities divided by total stockholders’ equity, which are found on the balance sheet. The higher the ratio is, the more debt a business uses compared to equity. A ratio that is too high can potentially cause problems in your small business. According to Corporate Finance Institute, this ratio may also be called a risk ratio, gearing or a leverage ratio.

Acceptable debt-to-equity ratios differ among industries. In general, a ratio that is greater than the industry average is too high. For example, if your small business has $400,000 in total liabilities and $250,000 in total stockholders’ equity, your debt-to-equity ratio is 1.6. This means you use $1.60 in debt for every $1 of equity, or your debt level is 160 percent of your equity. If the industry average is 0.9, you are one of the companies with a high debt-to-equity ratio.

Liabilities and equity represent the respective claims that creditors and owners have on a company’s assets. A debt-to-equity ratio increase means a reduction in the value of owners’ stake in a business as a proportion of its assets. If your small business has a high debt-to-equity ratio and you sell or liquidate the company, you would have to distribute a larger portion of the proceeds to creditors than if you had a low debt-to-equity ratio.

The risk of defaulting on, or being unable to repay, your debt increases as your debt-to-equity ratio rises. A reasonable amount of debt can help you grow your small business, but too much can overburden you with high interest payments. You have to generate more business just to break even. If you fail to make these interest payments, creditors might take your company’s assets or force you into bankruptcy.

Banks typically require a low debt-to-equity ratio when they extend new credit. Because a high debt-to-equity ratio reduces a bank’s chances of being repaid, it might refuse to provide additional funding or might give you money only with unfavorable terms. Say your debt-to-equity ratio is 2 and the bank’s cutoff is 1.5; it would likely deny you a loan.

Loan agreements often include covenants, which are stipulations that require a business to do or not do certain things, such as maintain adequate financial ratio levels. If your debt-to-equity ratio exceeds that allowed by a covenant with an existing lender, the lender might call your entire loan due. For example, if an existing lender requires you to keep your debt-to-equity ratio below 1.8 and it jumps to 2.1, you would violate the covenant.

Below are some common industries along with their associated debt-to-equity ratios, according to CSI Market, so you can compare yourself and see where your business stands.

• Energy: 0.61
• Technology: 0.62
• Retail: 0.93
• Financial: 1.02
• Healthcare: 1.06
• Services: 1.22

If, for example, you run a nail salon service with a debt-to-equity ratio of 1.34, you may want to consider trying to improve this ratio to get your business at or under the industry standard of 1.22. Doing so would help make your business finances more robust, as well as give a better chance at securing financing if needed.