Debt-to-equity Ratio: an Explainer
Worried that your business is not being financed effectively? Read on to learn how a debt-to-equity ratio can help.
As a business, you would want to know the ins and outs of your finances to truly understand how your business is performing. Financial ratios are a useful way for companies to gather valuable information from their financial statements and perform an analysis. If you are in a business that wants to borrow money or engage with investors, you should pay close attention to your debt-to-equity ratio. In this article, we explain how your business can benefit from a debt-to-equity analysis.
What is the debt-to-equity ratio?
This ratio is a measure of leverage: how much debt you use to run your business. So, by looking at the relationship between debt and equity, you can assess your business’s ability to meet its long-term financial commitments. Essentially, the ratio tells you how much debt you have for every dollar of equity. The calculation for debt-to-equity is simple:
Debt-to-equity ratio = total liabilities / shareholders’ equity
The total liabilities is the overall amount that your business owes to others. Shareholders’ equity is the total business assets minus liabilities. Both of these figures can be found in your business’s balance sheet.
If your business owes $4,500 to debtors and has $3,700 in shareholder’ equity, the debt-to-equity ratio would be $4,500 / $3,700 = 1.22. Therefore, for every $1 of equity, you would have $1.22 in debt.
What is a good debt-to-equity ratio?
It is important that you consider the size of your business and the type of industry your business is in. This is because the benchmark debt-to-equity ratio differs depending on the industry and company size. For example, most small to medium businesses prefer to keep their debt-to-equity ratio between the 1.5-2 range whereas larger public companies exceed a ratio of 2. The distinction between the two is mainly because the running of larger companies usually requires more financial resources. However, a good rule of thumb for smaller businesses is to aim for a debt-to-equity ratio of 1-1.5.
What does the debt-to-equity ratio mean for your business?
Investors look at your ratio to determine the level of risk investing in your business will carry. They also would want to use the figure to assess how effective and strategic you are in funding your business. Too high of a ratio would indicate a high risk, and an inability to generate enough cash to satisfy the business’s liabilities. However, too low of a ratio shows that your business is relying too heavily on its equity. This means that funds are being managed inefficiently, and the company runs the risk of a leveraged buyout. Therefore, the key is to establish an appropriate balance between debt and equity in your business.
Strategies to adjust your ratio
If your calculated debt-to-equity is too high, you should consider adopting strategies to reduce it. For instance, you can first review your manufacturing inventory to make sure your money is not wasted on unnecessary processes. You can then sell any non-essential assets and use the proceeds to pay off your debt. If you are borrowing at high-interest rates, you may want to consider refinancing your debt so you can borrow at more desirable rates.
If your calculated debt-to-equity is too low, consider increasing the level of debt financing your business utilises.
It is easy to shy away from debt and rely on equity to fund your business. However, that may not be the most effective way to maximise your profitability. As such, you should aim to strike a good balance between debt financing and equity financing. Making major financial decisions based on a calculated ratio is risky for your business if done incorrectly. You may not know what to include in the debt or equity components of your calculation which could significantly impact your figure. Therefore, we recommend you consult an experienced finance lawyer who can advise you further.
Zeinab is an intern working in our content team, which aims to provide free legal guides to facilitate public access to legal resources. She is undertaking a Bachelor of Laws with a Bachelor of Medical Science at the University of Technology, Sydney.