Last Updated: February 20, 2024
When exploring your financial landscape, especially in the context of securing loans or managing business finances, the term "debt to equity ratio" frequently pops up as a key indicator of financial health. But what exactly is this ratio, and why does it matter for your financial strategy and debt management?
Understanding the nuances of the debt to equity ratio is crucial for anyone looking to make educated decisions about leveraging debt in relation to their equity. This blog post aims to demystify this financial metric, providing clear definitions and insights into what constitutes a good debt to equity ratio and how it can impact your financial decisions and opportunities.
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What is Equity?
Equity, for people, is what you have that is worth money or that has grown in value. Homes are the most common types of equity. If you have a mortgage of $150,000 and the house is valued at $200,000, you have $50,000 in equity. Your total equity is all your assets minus liabilities.
Cars and boats generally don't have equity as they lose value over time. Stocks, jewelry, artwork, and similar items may or may not have equity. It depends on how much you bought it for and how much someone is willing to pay for it.
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What are Assets?
An asset is like equity but includes your after-tax income. We are going to use asset and equity to mean the same thing. This is because most people do not have a lot of equity but do have assets. Since the formulas are used in business, the terms remain the same in personal finance where your total assets are value of everything you own.
When calculating your financial health, one important measure to consider is your debt to asset ratio. This ratio compares the total amount of debt you owe to the total value of your assets. A lower debt to asset ratio suggests that you have more assets relative to your debts, which is generally a favorable financial position. Conversely, a higher ratio indicates you have more debt compared to your assets, which could signal financial risk.
What is Debt?
Debt is what you owe. Loans, credit cards, mortgages, student loans, and similar items feed into debt. It can be divided into long and short term obligations or debt, like mortgages and short term debt that is due within a year. Adding those together gives you total debt.
What is Debt to Equity Ratio?
A ratio compares one value to another. The debt to equity ratio compares how much debt you have to how much equity you have.
- Calculate all your assets
- Calculate all your debts
- Subtract debts from assets to get net worth
- Divide total debt by net worth
This should give you a number less than one. If it is more than one, you have more debt than assets or you have made an error.
For instance, you owe $100,000 and have total assets of $200,000. $100,000/$200,000 = 0.5 Multiply this by 100 to get a percentage. Your debt to equity ratio is 50%.
Alternatively, if you have total debts of $200,000 and equity of $100,000 (200,000/100,000), you have a debt to equity ratio of 2 or 200%.
The lower the debt to equity percentage, the better you are situated. The person in the first example is in a better finance place than person 2.
If you are not fond of math, there are online calculators that will help you figure out your company's total debt due to equity ratio.
What is a debt to asset ratio?
A debt to asset ratio is like a debt to equity ratio, except your after tax income is added into your equity. Most lenders use debt to asset ratio as a clearer look at debt to equity ratio. This adds in your after-tax income for a better idea of how easily you can to borrow money repay your debts.
Why Do I Need A Good Debt to Asset Ratio?
You can figure out debt to assets two ways. The first is all debt except mortgage. The second is with a mortgage. Let's break it down with some numbers.
Debt to asset without mortgage
Add together all debts (loans, credit lines, credit cards, etc.) and divide by after tax income. Let's say you have $10,000 in debts and an after-tax income of $59,000 (the median US income). Your debt ratio is 0.17 or 17%.
Debt to asset with mortgage
Add together all debts plus the total of 12 monthly mortgage payments and divide by after tax income. Using the same example, you have $10,000 in debt plus $12,360 (based on US averages) in mortgage payments and the after-tax income of $59,000 Your debt ratio is now 0.38 or 38%.
Your debt to asset ratio can give you a clearer picture of your overall financial health than the debt to equity ratio, as it takes into account all your assets, not just equity. Lenders often use this ratio to determine your ability to repay a loan. A lower ratio means you have more assets relative to your debt, which can make you a more appealing borrower.
What is a Good Debt to Equity Ratio?
Now that you have some numbers, what do they mean? The ideal debt to equity ratio, using the formula above, is less than 10% without a mortgage and less than 36% with a mortgage.
If you exceed 36%, it is very easy to get into debt. Most lenders hesitate to lend to someone with a debt to equity/asset ratio over 40%. Over 40% is considered a bad debt equity ratio for banks.
Similarly, a good debt to asset ratio typically falls below 0.4 or 40%. This means that your total debt is less than 40% of your total assets. Having a debt to asset ratio above this threshold could make it more difficult to obtain loans or favorable interest rates.
High and low debt to equity ratios
When you look at debt to equity ratios, a high ratio means you probably don't have enough equity to cover your debts.
A very low ratio also means you can take advantage of your equity to take out loans if you want.
A high ratio is anything over 40% or 0.4.
A low ratio is less than 36% (0.36) with a mortgage or 10% (0.1) without a mortgage.
People often have questions about specific debt to equity ratios. Let's answer them here.
- Is it better to have a higher or lower debt-to-equity ratio?
Answer: A lower debt to equity ratio is better. - Is a debt-to-equity ratio below 1 GOOD?
Answer: It means you have more assets than debt. - Is 0.4 debt-to-equity ratio good?
Answer: This is also 40%. It is not very good. - What does a debt-to-equity ratio of 2.5 mean?
Answer: It means you have 2.5 times the debt as assets. - Is 1.7 A good debt-to-equity ratio?
Answer: You have 1.7 times the debt as assets - Is 0.5 a good debt-to-equity ratio?
Answer: It is higher than banks like to see. - What does a debt-to-equity ratio of 0.8 mean?
Answer: You have almost more debt than you do assets - Is 10% a good debt-to-income ratio?
Answer: Yes. It is very good. - Is a debt-to-equity ratio of 75% good?
Answer: No. It is too high.
How to Improve your Debt to Equity Ratio
To improve your debt to asset ratio, you could focus on reducing your debts and/or increasing your assets. This could involve paying down loans, credit card balances, or other forms of debt, as well as increasing your savings or investments to grow your assets. It's important to approach this process gradually and sustainably, focusing on strategies that fit your financial situation and goals.
What if I can't improve my debt to equity ratio?
If you have credit card debt in excess of $10,000 and are having trouble paying it down, Pacific Debt, Inc may be able to help you out.
Contact one of our debt specialists for afree consultation.
Disclaimer: We are not attorneys or accountants and can not give you legal advice. If you have legal or tax questions, you should contact the appropriate expert.
Some Business Terminology
Whether you are an individual or small business owner, this concept applies to both. It's good to know what these terms mean.
Balance Sheet
A company's balance sheet details assets, liabilities, and shareholders' equity at a specific point in time. The balance sheet can indicate a company's financial health and where changes need to be made. Look online to find a balance sheet template. Before you invest, you may want to see the company's balance sheet.
Capital
Capital is the money or assets available to a company and is known as the company's equity. Companies may raise additional capital by offering stock. Some companies are in financial and manufacturing industries considered capital intensive industries. These capital intensive companies are ones that require land, buildings or plants, equipment, vehicles, or heavy equipment.
Cash flow
A company's cash flow looks at the amount of cash in and cash out. Cash flow can indicate the health of a a company finances. Companies also have a cash ratio that considers the cash or assets that can be turned quickly into cash versus debt.
Liabilities
Liabilities are the company's debt load. Assets minus liabilities can indicate the health of a company or financial distress of a family. A company's total liabilities are all the debts and commitments owed to a third party.
Financial leverage
A company's important financial metric of leverage is using a company's debt to buy assets. Debt to equity ratio is a form of leverage ratio.
Assets
A company's assets include cash, inventory, buildings, and property added to the intangible assets. Assets minus liabilities yields the net worth of a company personal assets.
Corporate finance
Corporate finance looks are sources of financing, corporate capital structure, actions that increase the value of the company's short term leverage back to the shareholders, and the tools used to allocate financial resources.
Finance operations provide financial advice and guidance to a company. Equity financing is the ownership of assets with attached liabilities. Finance growth is a method of mixing existing debt, and equity to entice lenders to lend money. Debt financing is selling bonds, bills or notes to raise capital. People have more debt financing options like credit card debt and loans from family.
Shareholders equity
The total shareholder equity is the amount of money that would be returned to shareholders if the company was liquidated. Total shareholders equity represents the net worth of equity shareholders in the company.
Disclaimer: We are not attorneys or accountants and can not give you legal advice. If you have legal or tax questions, you should contact the appropriate expert.
