Debt to equity ratio is the numerical value associated with all debt divided by the value of the equity section on the balance sheet. Most prudent investors are more concerned with a limited perspective of just the long-term debt against the entire equity.
Debt to equity ratios should never be used to make business decisions in isolation. Use a combination of other ratios, at least a dozen, when using ratios to make buy, hold, sell decisions.
Leverage refers to the ability to lift a heavier load using a fulcrum and a lever. The common image is a board on a triangular pivot point with a heavy weight (M1) on one end and a lighter weight (M2) on the other. As the lever shifts towards the lighter load it starts to lift the heavier weight. In effect, as the distance ‘b’ gets longer, it becomes easier to lift M1. This principle works with finances too. How so?
Every business buys on account whether it is a traditional vendor account like that found in retail or simply using a credit card. A third party provides credit which creates debt for the business. The debt ratio reflects the percentage of assets covered by debt.
The last of the leverage ratios isn’t really a pure leverage indicator but augments the debt ratio. Debt requires the payment of interest and so an indicator of the ability to pay this interest is needed. This is the interest coverage ratio.
Another leverage ratio used to evaluate the financial integrity of a business is the debt to equity ratio. It is strictly a bottom half balance sheet ratio. Its result explains the relationship of volume of debt and corresponding equity to finance the operations of a business, i.e. the purchase of assets.
In the arsenal of capitalizing a business operation, long term debt serves as one of the primary sources of capital. If you are an owner of a small business, you need to understand the relationship this source has to the overall financial status of the company. Too much debt and the owner is burden by the cash outlays to service.
