Debt to equity ratio is a key financial metric used to measure the financial health of a company. It is calculated by dividing the total liabilities of a company by its total shareholder capital. This ratio is important for investors, lenders, and shareholders as it helps them understand the risk associated with the company. The debt-to-capital ratio is a useful tool for understanding the financial health of a company, especially for those that hope to go public one day.
It compares the total balance of debt on a company's balance sheet with the value of the total capital of its shareholders. A higher debt-to-capital ratio means that the company in question involves more risks, although potentially more rewards. When calculating the debt-to-equity ratio, it is important to be clear about exactly what types of debt and equity are included in the calculation. For example, if a company uses very little external financing, through the conversion of debt to equity, it can be seen as an indication that the company is trying to become a wholly-owned company. Business debt isn't always bad, but it can be risky for lenders and shareholders. For lenders, existing debt on the balance sheet makes it riskier to work with the borrower, especially for risk-averse debt lenders.
For shareholders, more debt means that there are more claims on the company's assets with higher priority than that of shareholders. It is important to note that companies should not be too reluctant to increase their debt levels as this can cause them to lose growth opportunities to finance expansion plans. Additionally, they will not benefit from the “fiscal shield” against interest expenses. In conclusion, understanding and calculating the debt-to-equity ratio is an important step in assessing a company's financial health. It helps investors, lenders, and shareholders understand the risks associated with investing in or lending money to a particular company.
