- Your debt-to-equity ratio measures how much debt you have relative to your net worth.
- The ratio can also be used by small business owners and investors to identify potential risks in their business or an investment opportunity.
- The debt-to-equity ratio is just one of many metrics you can use to determine your financial health.
There are several different metrics you can use to measure your financial health. Your debt-to-equity ratio is one of them and can provide you with a snapshot of how much of your personal assets are being financed with debt.
If you have too much debt relative to your assets, it could become an obstacle to your financial goals. As such, understanding your relationship with debt can help you determine which steps you may need to take to get on the right financial track.
Additionally, if you're a small business owner or an investor, you can use the debt-to-equity ratio as a metric to judge the financial health of your business or a company you're thinking about investing in.
That said, debt-to-equity isn’t a be-all, end-all. Here’s what to know about this ratio, what it reveals and what it leaves out.
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What is a debt-to-equity ratio?
Debt-to-equity ratio is a corporate term used to measure how much debt a company is using to finance its assets compared to the amount of equity in the business for shareholders. This equity is calculated by subtracting the company's liabilities from its assets.
For example, if a corporation has $10 million in assets and $7 million in liabilities, that means it has $3 million in equity. To get the company's debt-to-equity ratio, you'd divide $7 million by $3 million, giving you a ratio of 2:3.
Some of the terminology may be different with personal finance, but you can use debt-to-equity ratio to determine your own relationship with debt. Instead of equity, though, you'll use your net worth.
If you have $200,000 in assets, for instance, and $150,000 in debt, your net worth is $50,000. To calculate the debt-to-equity ratio for this scenario, you'd divide your $150,000 in debt by your net worth of $50,000 to get a ratio of 3. In other words, you have $3 in debt for every $1 of funds that are yours, free and clear.
What is a good debt-to-equity ratio?
There isn't a lot of advice out there for personal debt-to-equity ratios, but for corporations, experts say that a ratio below 1 means that the company is relatively safe financially. If it's 2 or higher, the company may be at risk of being overleveraged, which can make it more difficult for them to pay back their debt.[2, 3]
The same may also be true for personal finances. If you have a $100,000 net worth, for example, and only $50,000 in debt, you're probably less likely to be stressed about your debt situation than if you had a $100,000 net worth and $200,000 in debt.
Of course, rules of thumb are just that. Every financial situation is different, and if you're relatively young, having a higher debt-to-equity ratio may not necessarily be cause for alarm. It takes time to increase your net worth, and many young professionals have a negative net worth due to student loans and smaller savings and investment balances.
Instead of focusing on your debt-to-equity ratio, it could be better to calculate your debt-to-income (DTI) ratio, which tells you how much of your gross monthly income goes toward debt payments. For example, lenders use your DTI instead of your debt-to-equity ratio for mortgage loans, auto loans and other financing options.
Why does your debt-to-equity ratio matter?
If you have a positive net worth, it means that you have enough assets to pay off all of your debt and still have some money left over. A lower debt-to-equity ratio means that you have fewer assets that are financed.
This is particularly important if you experience a financial emergency, such as the loss of employment, a short-term disability or a major home repair. If you have a low debt-to-equity ratio, you may be less likely to need to take out more debt to cover your expenses.
That said, the debt-to-equity ratio doesn't tell you what type of assets you have. Someone whose net worth is mostly made up of retirement accounts and real estate, for instance, may have a harder time covering debt and emergency expenses compared to someone who has a lot of cash in bank and brokerage accounts.
A debt-to-equity ratio also doesn't tell you about the cost of debt relative to your income.
"A person with a high-interest personal loan may have the same debt-to-equity ratio as someone with a low-interest car loan," says Stanley Himeno-Okamoto, a Certified Financial Planner and founder and wealth manager at DRS Financial Partners. "But their payments may have very different impacts on their financial situation. In this case, it's important to also look at the debt-to-income ratio."
|What debt-to-equity tells you||What it doesn’t tell you|
|How much debt you have relative to your net worth||How much of your income goes toward monthly debt payments|
|The proportion of your assets that are financed||How expensive the debt is and whether it's manageable|
How to use the debt-to-equity ratio as a business owner or investor
If you're planning to start a business or you already own one, the debt-to-equity ratio can give you an idea of the financial health of your business. Keep in mind, though, that a good debt-to-equity ratio can vary from industry to industry.
Meet the Expert
Stanley Himeno-Okamoto, a Certified Financial Planner and founder and wealth manager at DRS Financial Partners.
If you're a freelance contractor, for instance, a low ratio is common because you may not have a lot of equipment and little to no inventory. However, if you operate in a capital-intensive industry, such as manufacturing, even a debt-to-equity ratio above 2 may be satisfactory.
Do some research on your industry to get an idea of what your ratio should look like.
If it’s too low, it could be an opportunity to borrow more to invest in expanding your business
If it's too high, you may want to put a hold on growth while you tackle your debt, so you don't grow faster than you can handle.
Also, as an investor, you can use the debt-to-equity ratio, along with other metrics, to judge whether a stock is a good investment. Again, acceptable ratios can vary from industry to industry, and it's not the only metric to consider.[1, 2]
"In isolation, a high debt to equity ratio doesn't tell you much," says Himeno-Okamoto. "But it can suggest poor financial hygiene or excessive investment risk when evaluated alongside other metrics like a risk tolerance evaluation and a cash flow statement."
Focus on more than one metric to measure your financial health
The debt-to-equity ratio can give you a good idea of whether your debt burden is too high, but it doesn't measure…
The types of assets and liabilities you have
Your income and expenses
Your progress in investing
Other aspects of your financial plan
Because of these blindspots, it's important to look at your financial situation holistically to avoid getting caught up in just one area of your plan. Identify your top priorities and set goals to accomplish those objectives on your own timeline.
For instance, you might read up on debt-to-income ratios, how to calculate them and why they might be more useful for your personal finances.