Equity and debt are two of the primary methods that businesses use to raise capital. While you likely can’t avoid debt completely, keeping debt in check is a good way to demonstrate the financial health of your organization to potential investors. Your debt-to-equity ratio can summarize your company’s level of liabilities when compared to its ability to pay off debt.
If you understand the components of this financial measurement, you’ll be better prepared to talk with potential investors about why your business is making smart financial decisions.
What is a debt-to-equity ratio?
Your business’s debt to equity ratio (D/E ratio) is a financial ratio that shows the proportion of debt and equity you are using to finance your company.
D/E ratio can also be referred to as the debt-equity ratio, risk ratio, or gearing ratio. The D/E ratio is important because it indicates how much of shareholder equity can be used to pay off debt if the business ever declines.
This can give an indication of your capital structure and the financial health of the company. When the ratio is calculated it can also help others decide if they want to invest in your business.
When to use the debt-to-equity ratio
There are a number of uses for a business’ D/E ratio. Some of these uses include:
1. Transparency for investors
The D/E ratio provides transparency for investors by giving them a sense of a company’s financial leverage and risk profile. This information is critical in making informed investment decisions and assessing a company’s financial stability over the long term.
2. Understanding shareholders’ earnings
This financial metric is useful for understanding shareholders’ earnings because it provides information about the amount of debt a company is using to generate its earnings. A high D/E ratio may indicate that a company is taking on more debt to finance its operations, which can increase its financial risk. However, if the company is using the debt to finance projects that generate higher earnings than the cost of the debt, this can lead to higher earnings for shareholders.
The D/E ratio should be used in conjunction with other financial metrics and factors to get a complete understanding of a company’s financial health and potential for generating earnings.
3. Loan applications
Lenders typically look at a company’s D/E ratio when evaluating its creditworthiness and determining whether to approve a loan application.
A low D/E ratio can be an indicator that a company is less reliant on debt financing and has a strong equity base, which can be seen as a positive sign by lenders. This is because a company with a low D/E ratio may have a lower risk of defaulting on its debt obligations and may have a better ability to repay any loans.
Lenders may also compare a company’s D/E ratio to industry standards or benchmarks to gain a better understanding of its financial health relative to its peers.
4. Competitor comparisons
By comparing a company’s D/E ratio to its competitors, investors and analysts can gain a better understanding of how the company’s financial health and risk profile compare to its peers.
Debt-to-equity ratio formula
The debt-to-equity ratio formula is simple:
Debt-to-equity ratio = Total liabilities ÷ Shareholder equity
How to find debt-to-equity ratio
To use the D/E ratio formula, you’ll need to understand what total liabilities are. Total liabilities includes:
- Short-term debt
- Long-term debt
- Accounts payable
- Deferred tax liabilities
- Other fixed payment obligations
As such, the longer version of the D/E ratio formula can be written as:
Debt to Equity Ratio = (short-term debt + long-term debt + fixed payment obligations) / Shareholders’ Equity
Debt is just one type of liability, so your total debt might not describe your total liabilities. Because debt is part of your liabilities, it’s important to understand what this category describes.
Debt includes:
- Drawn line-of-credit
- Notes payable
- Bonds payable
- Long-term debt
- Capital lease obligations
Debt does NOT include:
- Accounts payable
- Deferred revenues
- Dividends payable
How to calculate the debt-to-equity ratio
To calculate your D/E ratio:
- Use your balance sheet to find your liabilities and equity
- Start adding and dividing your numbers
This means that if your total liabilities (short-term debt + long-term debt + fixed payment obligations) are $600,000, and your equity is $200,000, then your debt-to-equity ratio would be 3. I
f you are able to pay off some of your debt or liabilities, then you would be able to achieve a lower ratio.
A company with a ratio of 2 is borrowing twice as much as they have in equity, and a company with a ratio of 1 is borrowing exactly as much as they have in equity.
Debt-to-equity ratio example
Let’s see what this ratio can look like in the real world. As of September 2021, Microsoft had a long-term debt of $183.44 billion, and $151.98 billion in total shareholder equity. While this debt amount does not include all of the company’s liabilities, because Microsoft is such a large organization, it likely covers the majority of them.
$183.44 billion divided by $151.98 billion is 1.21, which is a pretty solid debt-to-equity ratio. While this is not the only number that investors can use to determine economic health, it is a useful indicator of how Microsoft prioritizes sources of capital.
What is a good debt-to-equity ratio?
Depending on industry, a D/E ratio can be relatively low or high:
- A low debt-to-equity ratio is financed by a relatively low level of debt and a high level of equity. Most businesses aspire to have a low ratio, which is usually considered to be below 2. However, this number can vary by industry.
- A high debt-to-equity ratio is financed more by debt from lenders than by shareholder equity, and this can put the organization at risk if the overall liabilities are excessive. A high ratio is usually 2 or above, depending on the industry.
Usually you want the debt-to-equity ratio of your business to be lower than 2. Some investors feel the ideal number should be a ratio of 1 or lower, as this indicates that all liabilities could be paid off with equity if the business falters.
Debt is risky, so investors often look for companies with a balance sheet that indicates a low debt-to-equity ratio—and thus a lower risk of defaulting on their loans.
Relatively high levels of debt aren’t necessarily a bad thing—it’s important to look at the complete picture to understand how businesses are using their debt to create profits. Companies with high levels of fixed assets, such as manufacturing, will likely have a higher ratio than 2.
How to reach a lower debt-to-equity ratio
If you have a high ratio of debt to equity and you are worried about how your business will fare during a downturn (or if you’re concerned about how it appears to investors), you may want to try lowering your overall liabilities.
The most direct way to do this is by paying down your loans. This can be a slow process, but careful budgeting can go a long way toward reaching this goal. A budget that aligns with your goals will help you find money in places you might not expect.
It may also be possible to restructure your debt when the market allows. You’ll also want to avoid taking on new debt, if possible.
You can also increase the profitability of your business to pay down debt—but running a very profitable business is likely one of your primary goals already. Once your overall debt is lower (or your equity is higher), you will have a lower ratio.
Budget with BILL
BILL allows businesses to set budgets, track expenses, and manage spending in real-time, all from one centralized platform. BILL offers advanced reporting and analytics tools, making it easy to track expenses, identify trends, and make data-driven decisions.
Overall, BILL provides businesses with a powerful tool for effective budgeting and expense management. Take control of your budgets today!
Want to finance your business with credit? BILL makes it easy for both new and established companies to build credit and manage corporate spending.
