The Basics of Debt Equity

Debt equity can be both fairly simple and quite complex, depending upon what type and amount of debt and equity you may possess. Simply defined, the debt-to-equity ratio is a financial figure calculated by comparing the proportion of shareholder equity to the amount of debt used to keep a business or company in operation. It is also commonly referred to as risk, gearing or leverage (as it is similar to leveraging). Your company's financial records (such as its balance sheets and profit and loss statements) are used to calculate this ratio. Debt equity also refers to the percentage of property owned by a home owner. 

What It Really Means

Your debt-to-equity ratio can mean much more than simply a ratio of two numbers: it essentially tells you (whether you are the company owner or a shareholder) how much money your company can safely borrow over an extended period. Why is it important for you to have this information? If you are a shareholder thinking of increasing your investment in a company and the company suddenly decides to borrow significantly more than its debt-to-equity ratio indicates is wise, your shares in the company could fall precipitously in value in the short term. This is especially true if the company fails to repay the money it has borrowed, leaving shareholders with what is essentially a worthless investment.

What to Look For

If you are a business owner looking to borrow money or if you are a potential shareholder interested in the financial future of a company, you need to pay especially close attention to the company's debt-to-equity ratio. What you should be looking for is whether the company's debt-to-equity ratio is above 40 to 50 percent. If the ratio is higher than 40 percent, this may indicate severe liquidity problems that may threaten the company's ability to remain financially viable in the future. If the company's current and/or quick ratios appear to be abnormally low, this is another red flag that serious financial trouble may be on the way.

Other Types of Equity Debt

Equity debt can also take the form of money borrowed on your home using your home as collateral. This was a particularly popular phenomenon in the late 1990s and early to mid 2000s as the housing market boomed. Of course, we all know how that played out for many homeowners who owe more on their mortgages than their homes are currently worth. If you do elect to borrow money using your home as collateral, it always pays to do so only in cases of an absolute emergency or if you know yourself to be a conservative spender and you always pay as much of your loan as possible at a time. 

Home Ownership

The debt-to-equity ratio can also refer to your mortgage situation, indicating how much you owe on your mortgage versus how much you have paid to the lender (or how much of your home you now own). If, for example, you buy a $350,000 house and pay $25,000 as your down payment, your home equity is calculated by subtracting what you paid ($25,000) from what you originally owed ($350,000). In this case, your equity is $25,000, and your debt is the remaining $325,000. Your equity increases with each payment you make to the lender until you have paid it all off and you own your home completely.


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