Canadian individuals and business must sometimes resort to borrowing money regardless of the interest rates.
In this article, we’re going to look at the debt-to-equity ratio. The debt-to-equity ratio is a measurement and an important financial ratio to be familiar with. We’ll look at what it measures, who it’s useful for, the formula, the difference between the debt-to-equity ratio and gearing ratio and how to calculate a company’s debt-to-equity ratio.
Debt to Equity Ratio Explained
What does it measure? Who is it useful for?
The debt-to-equity ratio (also known as the debt-to-total-assets ratio) is useful when evaluating a business’s financial leverage. It’s an important measure in corporate finance. It looks at how much a company is financing its day-to-day operations through borrowed funds (debt) versus wholly-owned funds (equity). In a worst case scenario, it spells out how much total shareholder equity could be used to cover the business’s debt should the company hit a rough patch.
The debt to equity ratio is useful for personal finances, too. It’s a lot like a debt ratio you may be pretty familiar with: the debt-to-income ratio. Similar to the debt-to-income ratio, the debt-to-equity ratio measures how much amounts of debt you’re carrying and how creditworthy you are in the eyes of a lender. The debt to equity ratio is most commonly used when applying for a mortgage. It looks at how much debt you’re carrying versus how much equity you have in your home.
From a personal finance perspective, it’s better to have more equity in your home than less. If you feel you have too much debt obligation, you can adjust your debt-to-equity ratio by buying a less expensive home, therefore needing a lesser mortgage amount. Or, you can save more aggressively to come up with a larger down payment. If you’re putting less than 20 percent down on your primary residence, you’re required to purchase mortgage default insurance, which protects the lender in the event that you have difficulties repaying your mortgage.
You can calculate a company’s debt-to-equity ratio by dividing its total liabilities by the shareholder’s equity. If you don’t know these figures, you can find them out by looking them up on the company’s financial statements on its company balance sheet. Similarly, you can calculate your own personal debt-to-equity ratio by dividing your total outstanding personal debts by your total personal equity.
Difference between D/E ratio and gearing ratio
It’s easy to use debt-to-equity ratio and gearing ratios interchangeably when there are actually some key differences to be aware of.
A company’s gearing ratio refers to a broad category of financial ratios, which includes the debt-to-equity ratio. The term “gearing” means financial leverage. Gearing ratios look at leverage more closely than other financial ratios. It’s widely believed that some leverage in a business is good, while too much leverage tends to not be so good.
It’s important to recognize that gearing is different from leverage. Leverage usually refers to how much debt a company takes on for the purposes of investing with the objective of achieving a higher rate of return. Meanwhile, gearing usually refers to how much equity a company has versus how much it’s borrowed.
How to Calculate Your D/E
To better understand how the debt-to-equity ratio works, it’s best if we run through an example together.
Let’s say ABC Company has total outstanding debts of $10 million and total shareholder equity of $8 million. In this case ABC Company’s debt to equity ratio would be 1.25 ($10 million debt divided by $8 million equity). Whether 1.25 is good largely depends on the industry in which the company operates. If you’re in a capital intensive industry and other companies are highly leveraged, 1.25 may be a low debt to equity ratio. But if other companies don’t have much debt, 1.25 might be high. For that reason, it’s important to compare a company’s debt to equity ratio to that of its peers to see if it’s in line or out of whack.
Similar to a company, you can calculate your own personal debt-to-equity ratio the same way.
Debt to Income Ratio
You’ll often hear about the debt-to-income ratio when you applying for a mortgage or you’re making a budget, but do you truly understand what it means?
The debt-to-income ratio looks at your gross (before tax) income versus your debt. Lenders use this ratio to consider your likelihood of paying back debt.
To determine your debt-to-income ratio, tally up all your outstanding debt – this includes your mortgage, credit card debt, car loan, student debt, line of credit, etc. – and divide it by your total annual before tax income. It’s recommended that you keep your debt to income ratio below 36 per cent, although with home prices skyrocketing in many Canadian cities, it’s ok if your debt to income ratio is higher, as long as you have a game plan to lower it over time. You can lower it over time by boosting your income and/or paying down your debt.
Your debt-to-income ratio comes in handy for another debt ratio mortgage lenders like to use: the debt service ratio. A lender can evaluate your debt service ratio in a couple ways: the gross debt service ratio and total debt service ratio. These ratios are used to determine the maximum amount of mortgage funds you’ll qualify for.
The gross debt service ratio looks at your mortgage payments, property taxes, heating expenses, and 50 percent of your maintenance fees versus your gross income. It’s used by lenders to see how much of your income would go towards a specific property relative to your income. Lenders typically want the gross debt service ratio to fall below 32 percent.
The second debt service ratio, the total debt service ratio, also factors in any other debt you might have, such as student debt, line of credit, credit card debt and car payments. Lenders typically want you to have a total debt service ratio below 40 percent.
If you’re concerned your debt ratios may be too high, reach out to our offices today. We’d be happy to work with you to help get your debt ratios in line.