Why the Debt-to-Equity Ratio Matters in Capital Structure

Broken piggy bank with money around it

In order for companies to profit in competitive markets, they need to understand their financial capabilities. Useful accounting tools, such as the debt-to-equity ratio, inform business managers how and when they can take risks and grow their company. The debt-to-equity ratio can help business managers understand the status of their debt to equity so that they can make knowledgeable decisions about important financial strategies for their company.

Understanding the Debt-to-Equity Ratio

The debt-to-equity ratio tells a company the amount of risk associated with the way its capital structure is set up and run. The ratio highlights the amount of debt a company is using to run their business and the financial leverage that is available to a company. Debt consists of the liabilities and obligations that are held by the organization, with the intent to pay them off over time. These include short-term debt, which is due within a year, and long-term debt with a maturity of more than one year (such as loans or mortgages). Company owners want to know if their debt is rising, decreasing, or staying steady. The answer indicates whether or not their company is being overwhelmed by financial obligations or has room to grow.

Calculating the Debt-to-Equity Ratio

Establishing a company’s debt-to-equity ratio requires a simple calculation. The calculation consists of dividing the total debt by the total equity. It is best for organizations to keep their debt-to-equity ratio at a manageable level, which is generally indicated by a ratio that is below 2. Sustaining a very low ratio would show companies that they may not be taking advantage of the cash they have for investment opportunities. This may put the company at risk for a leveraged buyout. Debt-to-equity ratios that are considered ‘safe’ or ‘average’ vary among different industries. Trends that are unique to industry should be considered when determining the significance of the ratio.

Uses for Evaluating Capital Structure

Acquiring Loans

Investors and bankers mainly use a company’s debt-to-equity ratio when determining whether or not they want to provide a loan to that company. How a company is paying for its business is critical information for an investor. Lenders and investors want to know if their money will be put to good use and, most importantly, if they will see a substantial return on their investment. If a company’s D/E ratio goes up, the lender may perceive there to be a greater risk and choose not to lend that company money. Bankers also use the ratio in connection with cash flow, revenue, and profitability figures. They compare this information with other companies in the same industry to determine potential risks.

Evaluating the Competition

Businesses can benefit from knowing how their debt-to-equity ratio compares to other competing businesses in the same industry. As markets fluctuate and industries go through changes, senior business managers benefit from an understanding of where their company stands relative to the competition. The debt-to-equity ratio can give managers an idea of whether it is advisable to take on more debt, push for investments in new projects, or if it is best to wait until the market changes.

Understanding What Impacts the Debt-to-Equity Ratio

Companies can benefit from being aware of how their day-to-day decisions affect their debt-to-equity ratio. This knowledge, in turn, can affect other financial aspects of the company. The management of cash flow accounts receivable and payable, and inventory can influence the final debt-to-ratio number. This final number can have an impact on how the company’s capital structure is perceived by investors and shareholders.

Considerations When Determining Debt-to-Equity

It is important to determine what to include in the liabilities portion of the debt-to-equity equation. Some companies choose to combine short-term and long-term debt, while other organizations choose to evaluate each separately. This is important because the ratio alone does not indicate when debts need to be paid. If the majority of debts are long-term, then a high debt-to-equity ratio is not as alarming as if debt payments are imminent.

Another consideration for small businesses lies in grasping the advantages of using debt to grow their business. It may seem counterintuitive to keep debt as opposed to paying it off, but a healthy balance of both debt and equity can be a more efficient way for businesses to expand.

In business, it can be difficult to know exactly when to take risks and when to play it safe. Investors and bankers require data and financial analyses to back up the risks they take. Tools like the debt-to-equity ratio provide a picture of a company’s capital structure and potential for success. Business administrators who comprehend the benefits, nuances, and importance of the debt-to-equity ratio can use this information to grow their companies in competitive markets.

Recommended Readings

Ohio University Blog, “Corporate Finance – An Overview”
Ohio University Blog, “How the Bullwhip Effect Impacts the Supply Chain”
Ohio University blog, “Investment 101 Cheat Sheet”

Learn More

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Accounting Tools, “Debt to equity ratio”
The Balance Small Business, “Debt-to-equity Ratio: How It’s Calculated and What it Measures”
Harvard Business Review, “A Refresher on Debt-to-Equity Ratio”
Investopedia, “Debt-to-Equity Ratio”