Whether you’re looking to invest in the stock market or take your business to the next level, there are a handful of crucial formulas and definitions to understand to help you get you where you want to be.
Especially relevant for businesses hoping to one day go public, debt-to-equity ratio is helpful in understanding the financial health of a business. D/E is used by lenders when determining potential loans, as well as investors to understand how well the business is performing.
In this guide, we’ll share what debt-to-equity ratio is, as well as cover why it's important to understand it for both investors and business owners.
What is debt-to-equity ratio?
A business’s debt-to-equity ratio, or D/E ratio, is a measure of the extent to which a company can cover its debt. It is calculated by dividing a company’s total debt by its total shareholders’ equity. The higher the D/E ratio, the more difficult it may be for the business to cover all of its liabilities, as it signals a company’s debt is quite high compared to the company's assets.
For example: $200,000 in debt / $100,000 in shareholders’ equity = 2 D/E ratio
A D/E can also be expressed as a percentage. In this example, a D/E of 2 also equals 200%. This means that for every $1 of the company owned by shareholders, the business owes $2 to creditors.
Since there are many ways to calculate the debt-to-equity ratio ratio, it’s important to be clear about exactly which types of debt and equity are included in the calculation within your balance sheets. Debt-to-equity ratio is often used by banks and other lenders to determine how much debt a business may have. In addition, D/E is often used as one of the key metrics investors look at before deciding to write a check.
The debt-to-equity ratio takes into account both short-term debt as well as long-term debt. Short-term debt refers to borrowings that are just that: short term. This could be a couple of months or as much as six to 12 months. Long-term debt, in this case, generally refers to the equity shareholders have invested in the business long term. The D/E formula helps investors and business owners understand what percentage of debt is short term, and how much is due to shareholder equity (long-term debt.)
A high D/E ratio suggests that a business may not be in a good financial position to cover debts. Debt in business isn’t always a bad thing, of course, but the equity ratio helps present an accurate picture of the current health of a business.
Debt/equity ratio: types of debt
A D/E ratio can include some or all of the following types of debt:
- Short-term liabilities
- Long-term liabilities
- Accounts payable
- Accrued liabilities
- Leases and other financing arrangements on your company's balance sheet.
The D/E ratio is especially important for a business using debt financing to raise more capital. Equity financing is an incredibly popular method for businesses looking to expand quickly. Understanding how much shareholder equity is already committed to a business is a useful metric for potential investors. Bank loans also often reference the D/E ratio when determining whether a loan is approved or denied, as well as how much capital the loan is worth.
What a D/E ratios means
A high debt-to-equity ratio generally means that in the case of a business downturn, a company could have difficulty paying off its debts. The higher the D/E, the riskier the business. Startups or companies looking to grow quickly may have a higher D/E naturally, but also could have more upside if everything goes according to plan. Investors use the D/E ratio as a benchmark to determine the risk of investing in a business. D/E is especially relevant when a business uses creditor financing.
However, there are industries where a high D/E ratio is typical, such as in capital-intensive businesses that routinely invest in property, plant, and equipment as part of their operations. On the other hand, lifestyle or service businesses without a need for heavy machinery and workspace will more likely have a low D/E. Holding short-term debt is a reality of many businesses, and a D/E ratio helps put that short-term debt in perspective compared to other company assets.
While lenders and investors generally prefer that a company maintain a low D/E ratio, a low debt-to-equity ratio can also suggest that the company may not be leveraging its assets well, limiting its profitability.
What is debt-to-equity ratio FAQ
What does a debt-to-equity ratio of 1.5 mean?
A debt-to-equity ratio of 1.5 would suggest that the particular company has $1.50 in debt for every $1 of equity in a business. A debt-to-equity ratio shows how much debt a business has compared to investor equity.
What is a good equity to debt ratio?
A good debt-to-equity ratio is highly contextual based on the business and industry. However, in general, a debt-to-equity ratio close to 2 or 2.5 is often considered strong.
Is a higher debt-to-equity ratio better?
In general, a higher debt-to-equity ratio means that the business in question carries more risk, though potentially more reward. Depending on the type of business and industry, a high debt-to-equity ratio does not necessarily mean the business is in bad shape.