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 the formula, what it measures, and who it’s useful for. Learn the difference between a debt-to-equity ratio vs. a 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. First, it considers how much a company is financing its day-to-day operations through borrowed funds (debt) versus wholly-owned funds (equity). It spells out how much total equity shareholders 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 is similar to a debt-to-income ratio. The debt-to-equity ratio measures how much debt you’re carrying and how creditworthy you are to a lender. The debt to equity ratio is most commonly used with mortgages. It looks at how much debt you’re carrying versus how much equity you have in your home.
Debt to Equity in Personal Finance
Debt to equity from a personal finance perspective is best to leverage in your home. If you have too much debt obligation, then you can adjust your debt-to-equity ratio by buying a less expensive home. Or, you can save more aggressively to come up with a larger down payment. If you put less than 20 percent down on your primary residence, then you must purchase mortgage default insurance. It 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, then you can find them out by looking them up. They are in the company’s balance sheet on the company’s financial statements. Similarly, you can calculate your own personal debt-to-equity ratio. To do so divide 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. However, 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 isn’t.
It’s important to recognize that gearing is different from leverage. Leverage refers to how much debt a company takes on for the purposes of investing. The objective is to achieve 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 Personal Debt to Equity Ratio
To better understand how the debt-to-equity ratio works, let’s try to 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, then 1.25 may be considered 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. 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, firstly. Secondly, 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 will include your mortgage, credit card debt, car loan, student debt, line of credit, etc. Then divide it by your before-tax annual income amount. The industry recommends you keep your debt to income ratio below 36 per cent. Although home prices are 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.
Calculate Financial Liability
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 of ways. The first is a gross debt service ratio and the second is a total debt service ratio. These ratios determine the maximum amount of mortgage funds you’ll qualify for.
The gross debt service ratio looks at the real-estate maintenance costs versus your gross income. It includes your mortgage payments, property taxes, heating expenses, and 50 percent of your maintenance fees. It’s used by lenders to see how much of your income would go towards a specific property. 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.