How to Calculate Debt to Equity Ratio?

One of the best ways to determine the financial situation of a company or individual is to calculate the debt ratio. It is a key indicator in finance because it evaluates one's financial health, the quality of management and solvency. It, therefore, makes it possible to know if a borrower has the potential ability to repay a loan. It is a reliable "thermometer" of a financial health.

HelloSafe has put together this guide to help you get to grips with the debt ratio, learn how to calculate it and how to analyze the results.

What is debt ratio?

The definition of debt ratio, also called gearing ratio, is simple: it is a tool for measuring the level of debt and solvency. It is a simple calculation that gives the level of debt borne by a company or an individual.

The result of the calculation is a percentage or a figure derived from the comparison between two financial values, generally equity and debt. This ratio indicates the ratio between these two values.

To find this ratio, we will divide the debts by the assets. This calculation will give a financial indicator, an analysis of the level of debt, and an indication of the financial dependence on third parties. In general, it allows you to know the profitability of a company.

For a bank, the debt ratio allows it to assess the financial health of a company or individual, and thus to make decisions regarding the granting of a person loan or business loan. Thanks to this ratio, the bank can know the extent of a borrower's borrowing capability.

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How to calculate debt ratio?

The debt ratio is calculated as follows:

In this calculation:

• Net debt is the loans already taken out by the business or individual
• The equity is the shareholders' equity such as salaries, capital ( the contribution of the partners, if it is a society), all the income, as well as the reserves (reinvested profits, net profits or losses for the year).

Let's take the following balance sheet as an example.

Assets	Liabilities
Real estate assets: $1,200	Equity: $750
Income: $150	Financial debts: $570
Value of furnishings: $80	Operating liabilities: $560
Cash flow: $100	-
Total assets: $1,510	Total liabilities: $1,730

In this example, the calculation of the debt ratio is as follows:

This results in a debt ratio of 52%. The higher the debt ratio of an organization, the greater its dependence on third parties. Around 50%, there is financial stability.

How to calculate the debt ratio for a mortgage?

The calculation of the debt ratio, during a real estate acquisition, will allow you to know the solvency of the buyer for the repayment of a mortgage loan. This is done by taking into account two types of debt ratios:

The GDS ratio, or Gross Debt Service ratio:

The TDS ratio, or Total Debt Service ratio:

In both of these calculations, "Gross Annual Income" refers to all amounts received during the year by the business or individual under study, before any deductions.

These two rations are expressed as a percentage of debt. According to the latest reports, to be able to comfortably repay a mortgage, these ratios must be below 33-36% for GDS and 40-42% for TDS.

Generally speaking, the TDS ratio is the more widely used of the two because it is more revealing than the GDS: it takes into account all debts, not just the costs associated with the property purchase and mortgage.

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What is a good debt ratio for an individual?

For an individual, a good debt ratio in Canada is between 3 and 37% at most.

To calculate this ratio, we use the following method:

Note that this calculation does not take into account expenses such as food, telephone, transportation, water and electricity charges.

The lower the debt ratio, the greater the financial capacity of the individual: he or she has little debt compared to his or her income and will therefore be considered by lending institutions as solvent, unlike an individual with a high ratio.

The lower the debt ratio, the greater the financial capacity of the individual: he or she has little debt compared to his or her income and will therefore be considered by lending institutions as solvent, unlike an individual with a high ratio.

For example, a person with a debt ratio exceeding 35-40% will be considered to be in a situation of over-indebtedness: his or her remaining balance is too low compared to the repayments he or she owes to his or her creditors.

How to calculate the debt ratio of a company?

To calculate the debt-to-equity ratio, net debt is divided by equity and multiplied by 100 to obtain the overall debt-to-equity ratio as a percentage:

• The net debts are the short, medium and long-term debts, as well as all the bank debts, which are therefore the external resources used.

• Equity is the company's assets, i.e. capital, partners' contributions, reinvested earnings reserves or the company's profits.

However, it is also possible to calculate the financial debt ratio using another formula. This other ratio takes into account only the financial debts and not the total debts.

• The company has taken on financial debts from lenders to finance its operating and investment needs. Financial debts allow the company to finance its investments and acquisitions on a long-term and sustainable basis. They consist of loans, various forms of credit, cash advances, etc.

To determine the information necessary for this calculation, it is necessary to refer to the company's budget.

This debt ratio provides an indicator of a company's solvency but also shows a potential lender the ability to repay a loan by a given deadline.

What does the debt-to-equity ratio say about the financial health of a company?

A good debt ratio for a company is usually between 30 and 50% - more precisely around 40%. However, this general rule depends mainly on the sector of activity but also the size of the company.

Similarly, a large company will be more likely to invest than an SME or VSE.

Thus, the debt ratio shows the dependence of a company on third-party lenders. The higher the ratio, the more dependent the company is, and the more likely it is to lose control of its finances and its decision-making power. The profitability of such a company can therefore be impacted. Conversely, a low debt ratio means independence and good financial health.

What does a debt to equity ratio greater than 1 mean?

A ratio greater than 1 - or 100% - means that a company has more liabilities and debt than assets. This means that a significant portion of the debt is financed by its assets.

As a reminder:

• Liabilities include all debts that the company has incurred to creditors. These debts are used to finance the assets.
• The assets are the company's property: real estate, inventories, advance payments, receivables, investments, securities, cash in bank accounts, etc. Generally speaking, everything that generates income is considered an asset.

A ratio higher than 1 may be temporarily acceptable if the company is pursuing a strategy of increasing its operations and making significant investments. But outside of these specific cases, a debt ratio higher than 1 is of course a very worrying indicator for a company.

How to calculate the total debt ratio?

The total debt-to-equity ratio is calculated as follows:

This is the leverage that the company uses to operate. If this indicator is low, the company will not need to call on external funds to operate. If it is higher, it shows a dependence on external capital to operate.

In the numerator, "Assets" is the sum of short-term and long-term debt.

For example, a company, at the end of 2021, has $91 million in assets and $53 million in equity. Therefore, we have:

This company thus uses $0.42 of debt for $1 of equity: its debt represents 42% of its equity.