Growing a business requires investment capital. Scaling businesses need money to launch products, hire employees, service customers, and expand. There are numerous ways to raise capital, and each will have a different impact on your company and the pace at which you grow.
The most common way to raise capital is through either equity or debt. But what do each of these entail? And how do they help your business’ financial standing? Well, you’re in luck, because we’ll take a look in this definitive guide to demystifying the debt to equity ratio.
Debt to Equity Ratio
The debt to equity ratio is a measure of a company’s financial leverage, and it represents the amount of debt and equity being used to finance a company’s assets. It’s calculated by dividing a firm’s total liabilities by total shareholders’ equity.
Leverage is the term used to describe a business’ use of debt to finance its business activities and asset purchases. When debt is the primary way a company finances its business, it’s considered highly leveraged. If it’s highly leveraged, the debt to equity ratio also tends to be higher.
The debt to equity ratio is a simple formula to show how capital has been raised to run a business. It’s considered an important financial metric because it indicates the stability of a company and its ability to raise additional capital to grow.
As an entrepreneur or small business owner, the ratio is used when you’ve applied for a loan or business line of credit. The debt to equity ratio tells lenders how financially stable your business is and if you’re able to make loan payments.
And for investors, the debt to equity ratio is used to indicate how risky it is to invest in a company. The higher the debt to equity ratio, the riskier the investment.
To further clarify the ratio, let’s define debt and equity next.
What is debt?
Debt is an amount owed for funds borrowed from a bank or private lender. The lender agrees to lend funds to the borrower upon a promise by the borrower to pay back the money as well as interest on the debt — the interest is usually paid at regular intervals. A business acquires debt in order to use the funds for operating needs.
A company typically needs hard assets to borrow money from a bank or private lender. A hard asset is a receivable for product or service delivered that is recognized on the company’s balance sheet and shows a lender the business is capable of paying back the loan. If a company is new or doesn’t have hard assets it’s more difficult to borrow.
What is equity?
Equity is stock or security representing an ownership interest in a company. Put simply, it’s your ownership in an asset — such as a company, property, or car — after your debt on that asset is paid.
When a business uses equity financing, it sells shares of the company to investors in return for capital. To learn more, check out this guide to equity financing.
What is a good debt to equity ratio?
A good debt to equity ratio is around 1 to 1.5. However, the ideal debt to equity ratio will vary depending on the industry because some industries use more debt financing than others. Capital-intensive industries like the financial and manufacturing industries often have higher ratios that can be greater than 2.
A high debt to equity ratio indicates a business uses debt to finance its growth. Companies that invest large amounts of money in assets and operations (capital intensive companies) often have higher debt to equity ratios. For lenders and investors, a high ratio means a riskier investment because the business might not be able to produce enough money to repay its debts.
If a debt to equity ratio is lower, closer to zero, this often means the business hasn’t relied on borrowing to finance operations. Investors are unlikely to invest in a company with a very low ratio because the business isn’t realizing the potential profit and value it could gain by borrowing and increasing operations.
Debt to Equity Ratio Formula
Now that we’ve defined the debt to equity ratio, we’ll take a look at how to use it. Below is the formula to calculate the debt to equity ratio:
Debt to equity ratio = Total liabilities / Shareholders’ equity
And here are the two elements that make up the formula:
- Total liabilities: Total liabilities represent all of a company’s debt, including short-term and long-term debt, and other liabilities (e.g., bond sinking funds and deferred tax liabilities).
- Shareholder’s equity: The shareholder’s equity is calculated by subtracting total liabilities from total assets. Total liabilities and total assets are found on a company’s balance sheet.
Debt to Equity Ratio Example
Let’s say a software company is applying for funding and needs to calculate its debt to equity ratio. Its total liabilities are $300,000 and shareholders’ equity is $250,000.
Here’s what the debt to equity ratio would look like for the company:
Debt to equity ratio = 300,000 / 250,000
Debt to equity ratio = 1.2
With a debt to equity ratio of 1.2, investing is less risky for the lenders because the business isn’t highly leveraged or primarily financed with debt.
Long-term Debt to Equity Ratio
The long-term debt to equity ratio shows how much of a business’ assets are financed by long-term financial obligations such as loans. The ratio is calculated with the following formula:
Long-term debt to equity ratio = Long-term debt / Shareholders’ equity
Examples of long-term debt include mortgages, bonds, and bank debt. Just like the standard debt to equity ratio, investing in a business is riskier if it has a high ratio.
The debt to equity ratio is a valuable tool for entrepreneurs and investors, and it shows how much a business relies on debt to finance its purchases and business activities. If you’re interested in entrepreneurship, learn about how to start a business next.