A debt equity ratio is something you might hear mentioned when a business’ or company’s finances are being discussed. Simply put, it is a comparison of the amount of debt a company has to the actual assets the company owns. If you are looking at your own personal finances, you can use the ratio to compare the amount of debt you have to what you’ve already paid off. For example, you can look at the amount you still owe on your mortgage to the equity you’ve built up in the home. You can use the ratio to get a sense of your financial stability or to see how far you have to go until you’re financially stable or secure.
Using the Ratio
How the debt equity ratio works depends on whether you are calculating it for your own personal use or if a business is calculating it. Typically though, the lower the ratio is, the better, as a higher ratio means that you are taking out more and more debt, but not increasing your worth. As an individual, you might want your ratio to be close to zero, while Investopedia notes that a major car company might prefer a ratio closer to 2.
Net Worth
Another way to look at the debt to equity ratio is as your debt compared to your net worth, which is the same as equity. Your net worth is the amount of assets you own minus the amount of debt you have. If you have a home than is worth $250,000 and a $150,000 mortgage, plus a retirement account that is worth $10,000, your net worth is $110,000. In that case, your ratio of debt to equity is more than one, or 150,000 divided by 110,000.
Ideally, you want your net worth to increase over time, while your debts decrease, which will lower your debt to equity ratio. For example, if your home increases in value to $300,000 over five years, while the amount you owe on the mortgage falls to $100,000, and the amount in your retirement account increases to $25,000, your net worth has increased to 225,000 and your debt equity ratio has fallen to 0.44.
Not to Be Confused with. . .
Another ratio you might hear about, especially if you are applying for a mortgage or other form of credit, is your debt to income ratio. While the debt to equity ratio considers what you owe to your financial worth, your debt to income ratio compares what you owe each month to what you earn. It’s commonly used as a way to gauge whether or not you’ll be able to repay the debts you do have. Usually, your debt to income ratio can’t be higher than 43 percent if you want to apply for a qualified mortgage, according to the Consumer Financial Protection Bureau.
You also don’t want to confuse your debt to equity ratio with your credit utilization ratio, a number used to evaluate your credit worthiness and to figure out your credit score. It’s the amount of debt you currently have, compared to the amount you could have. The lower your utilization ratio, the better your credit, for the most part.
No matter which ratio you are focusing on, a good rule of thumb to remember is that the lower the number, the better. Think about how much debt you want to have, compared to what you want to own, and use that as a guideline as you work to map out your financial future.
Image Source: Flickr
[cf]skyword_tracking_tag[/cf]