What is the Debt to Equity Ratio?
Debt to Equity Ratio is a calculation used to help determine the financial health of a company based on how much debt the company has in comparison to the amount invested by the owners.
The Debt to Equity Ratio is most commonly calculated as: Total Debt divided by Total Equity.
Debt is all liabilities of the company and Equity is the value of the Share Capital plus the Retained Earnings.
For example, if a company has $150,000 of total debt (owing to vendors, Canada Revenue Agency and bank loans); Share Capital of $10,000 and Retained Earnings of $400,000 then the calculation would be:
$150,000 total debt – $410,000 total equity (Share Capital + Retained Earnings) = Debt to Equity Ratio of 0.36. Debt represents 36% of the company’s overall finances.
The higher the Debt to Equity Ratio, the higher the risk that the company may be unable to repay their debt. The lower the Debt to Equity Ratio, the lower the risk of investing or lending to the company. The acceptable range of Debt to Equity ratio varies based on numerous factors such as the type of assets held, the stability of the business environment, and any existing regulations and restrictions within the industry. The bank or potential investors may calculate your company’s Debt to Equity ratio and compare it to industry standards to help gauge the risk level of investing in or loaning to your company.
Banks may be willing to include shareholder loans on the equity side of this ratio calculation if there is a signed agreement to postpone the repayment of the shareholder loans.
The Debt to Equity Ratio is a key ratio to monitor as banks often impose restrictions within bank loan covenants on the maximum Debt to Equity Ratio to help reduce their risk of bad loans.
Dawn Loeffler, BA (Hons), CPA, CA
Manager, Gilmour Group CPA’s
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