Debt-to-Equity Ratio Explained
The debt-to-equity ratio is a helpful metric to understand the financial health of a business. Though the D/E ratio is often used by entities outside the business, knowing your debt-to-equity ratio will help you understand some key elements of how your business is run.
A company's debt ratio is commonly used by lenders to determine the viability of loans and by investors as a basis to understand the performance of a business. It’s essential to understand how to interpret this ratio, especially when assessing the prospects of businesses in different industries. Depending on the industry, a higher ratio isn’t always a red flag.
What Is the Debt-to-Equity Ratio?
The debt-to-equity ratio is a metric that shows how much debt a company has compared to its assets. It is simple to work out this ratio: divide the company's total debt by total shareholder equity. A higher D/E ratio suggests that the company could have more difficulties covering its liabilities than another with a lower D/E ratio in a downturn.
Another way to explain this ratio is that it's a measure of how much debt you need to run your business. The debt-to-equity ratio is one of a number of ratios referred to as "leverage ratios" which reveal how and how much a company uses debt. This will differ depending on the nature of the business.
The D/E ratio is also a useful metric when asking for a bank loan as it's used to determine the company's financial leverage. Indeed, banks will often reference the D/E ratio when deciding whether to approve or deny a loan.
Example D/E Ratio Calculation
A company's balance sheet that reflects $200,000 in debt and $100,000 in shareholders' equity has a D/E ratio of 2: $200,000/$100,000= 2.
The D/E can also be expressed as a percentage. In this case, the company's D/E would be 200% because, for every $1 of shareholder equity, the business owes $2 to its creditors.
Pro Insight: The D/E Ratio Is Only One Piece of the Financial Picture
While knowing your D/E ratio is useful, your company balance sheet, cash flow statement, and profit and loss statement offer additional pieces of information about how your business is doing financially. A small business accounting agency can help you understand how to leverage your company's revenue and debt to its best advantage and, if your debt-to-equity ratio is uncomfortably high, advise you on how to prevent debt from becoming a problem going forward.
Types of Debt
The D/E ratio takes both long-term debt and short-term debt into account. A short-term debt consists of loans that must be paid back within one year or less. Long-term debt refers to loans that will be repaid in more than one year, such as mortgages for commercial property and business loans.
A D/E ratio can include any of the following types of debt:
Short-term liabilities
Long-term liabilities
Accrued liabilities
Leases or other fixed payment obligations on your company's balance sheet
With this in mind, businesses can calculate their debt-to-equity ratio using either one of the following formulas:
Debt to Equity Ratio = Total Debt / Shareholders’ Equity
Or
Debt to Equity Ratio = (long term debt + short term debt + any fixed payment obligations) / Shareholders’ Equity
Equity or Debt Financing?
Companies can choose between two types of financing to raise capital: equity financing and debt financing. The way a company chooses to raise its capital will affect its D/E.
A company with more equity financing will have a lower D/E ratio than one that relies more on debt. However, some business owners prefer to finance their company through debt to avoid giving up more of the ownership of the company.
How to Interpret a Debt-to-Equity Ratio for a Business
A high debt-to-equity ratio suggests that a company might have difficulties paying off its debts in the case of a downturn in business. Generally speaking, the higher the D/E ratio, the riskier it will be to get involved. That said, startups or companies with ambitions to grow quickly may have a naturally higher D/E ratio without it being considered an extremely high-risk investment.
How Do Debt-to-Equity Ratios Vary Across Industries?
In some industries, a high D/E ratio is commonplace. This includes capital-intensive industries that need to routinely invest in property or equipment as part of their business operations. Imagine a construction company's total liabilities; a company like this that requires constant investment in equipment is likely to have a significant amount of debt. This isn’t a problem as long as the company’s cash flow allows it to pay its debt.
Conversely, lifestyle or service businesses without the need to invest heavily in machinery or workspace are more likely to have a lower D/E ratio.
What Is Considered a Good Debt-to-Equity Ratio?
As previously discussed, a good debt-to-equity ratio can depend on the industry you're in. As a rule of thumb, however, a D/E ratio below 1 is considered fairly safe and a D/E above 2 would be considered risky. Debt-to-equity ratios also vary significantly around the world. According to OECD data, the D/E ratio of U.S. financial corporations in 2022 was 2.3 compared to an average D/E ratio of 0.5 in Luxembourg and 10.2 in Australia for the same period.
Can a Higher Debt-to-Equity Ratio Ever Be Better?
Generally, more debt in relation to equity means investing in the business carries more risk. But this isn't always the case as not all debt is equal. Investors must understand the nature of the industry to determine whether or not a high D/E ratio is a potential red flag.
A high D/E can be positive when it shows that a company can easily meet its debt obligations through cash flow. In this case, the firm would be using the leverage to increase returns in equity.
Understand the Importance of Your Business's Debt-to-Equity Ratio
Having a good understanding of how your business runs and its overall financial health is essential for small business owners. This is because having a realistic picture of how your company is doing will allow you to make well-informed decisions about its next steps.
Knowing how to interpret your business’s debt-to-equity ratio—and how to improve it—is just one of many financial aspects of running a successful business. Reach out to an experienced accounting professional who can help you with this and other business-related financial matters.
