Strategic Planning: Gauge Your Risk Levels
In terms of strategic planning, the mix of your debt and equity indicates your risk level. Although other ratios fall into this group, your debt-to-equity ratio is the key to figuring your risk of how leveraged you are or aren’t.
Debt-to-equity ratio says a lot about the general financial structure of your company. This ratio measures the relationship of liabilities, or other people’s money, in the business to the owners’ or shareholders’ money in the business. Often, banks are the largest component of other people’s money, and they watch this ratio very closely, hoping to see plenty of equity to support the debt.
To calculate debt-to-equity, you divide total liabilities by owner equity, as in the following example.
The fictional Konas Corp. has $110,000 in total liabilities and $389,000 in owner equity, for a debt-to-equity ratio of 0.28. In other words, for every dollar Konas’s owners have put into their business, other people have put in 28 cents. The other people can feel fairly safe with a cushion this comfortable, meaning the company isn’t over leveraged.
Companies should be concerned when liabilities outweigh equity. That said, every industry has a debt-to-equity ratio that’s considered acceptable, and what’s considered acceptable in one industry may not be in another industry, because some businesses require higher capital investment than others.