What Does It Mean?
A debt to equity ratio analysis measures the way an organization funds its growth and how efficiently shareholders’ equity is being utilized.
Debt to equity is a valuable financial analytics tool designed to measure how a company can manage its existing equity, or if it is instead fueling expansion with a high amount of debt. Debt to equity ratios can be used to gauge the lost value of potential earnings, the risk level of a company, and more.
Why Does It Matter?
Understanding and properly measuring debt to equity ratios is vital to comprehending a business’s risk and its real growth. When expansion and operations are fueled largely by accumulating debt, earnings may seem high, but they are generally inflated.
Higher debt to equity means that earnings are diluted. Moreover, it also implies that companies face a higher risk of default.
Measuring debt to equity is an important way of ensuring that a company is keeping its debt in check while trying to reach profitability and can help prevent serious financial troubles down the road.
How Do You Measure the KPI?
To measure the debt to equity ratio, the first step is to calculate both short-term debt such as credit cards and credit line expenses, as well as long-term debt such as mortgages and loans. This number is divided by the total equity distributed to shareholders.
For example, if total liabilities equal $500,000 and total equity is $250,000, the debt to equity ratio would be 2.
What Data Sources Would You Use to Measure the KPI?
Measuring debt to equity requires understanding all the debts incurred by a company’s operations. To measure debt to equity, you should track data from expenditures, credit, outstanding debts, and assets.
Give Me An Example…
Imagine that your company has seen tremendous growth in a short period of time, but earnings and investor dividends don’t add up. Instead of being able to reinvest them, they’re mostly being used to cover existing obligations. Financials are also on the decline despite the fast expansion.
A debt to equity ratio interpretation offers a clear indicator of how your finances look (which you can visualize with a financial dashboard). A ratio above 2.0 may indicate that you have too much debt and could be a signal to rein in spending to return to a more balanced state.
What Benchmarks/Indicators Should I Use?
- Short-term liabilities
- Long-term liabilities
- Shareholder equity