July 12, 2022
Explainer

How your debt-to-equity ratio can help you better understand your financial picture

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Debt-to-equity ratios are often discussed in investing circles, but they are also an important number to keep track of as a business owner or internal finance department. 

In investing, this number is used to analyze potential stock purchases. A high debt-to-equity ratio signals risk for an outside investor. 

Part of the reason for knowing your debt-to-equity ratio is important is exactly that—it affects your ability to raise capital and receive programmatic funding from lenders and investors.  

More importantly, this metric gives you and your team insight into the financial health of your business and helps guide strategic decisions. Is now the best time to invest in growth? Is the business at risk of becoming insolvent? These are the types of questions that debt-to-equity ratios untangle. 

This article will cover the ins-and-outs of debt-to-equity ratios, including how to calculate it, how to interpret it, and benchmarks by industry. 

What is the debt-to-equity ratio?

In business, debt-to-equity ratio (D/E ratio) is a metric that can be used to give more insight into the financial health of a company. It measures the amount of money a business has borrowed vs the amount that is “owned.”

The D/E ratio is expressed as a percentage. The higher the percentage, the higher the proportion of debt a business has compared to shareholder equity. 

Although it is useful to know, your D/E ratio is not a standalone metric. It’s best to combine it with other financial information such as profitability calculations, operating margins and other financial metrics. 

Debt-to-equity ratio formula and calculation

Debt-to-equity is calculated by taking your total liabilities and dividing them by shareholder equity. In other words, take money the business owes and divide it by money the business has. 

Debt ratio = total liabilities/shareholder equity

Although the formula is simple, using it properly requires a thorough understanding of what counts as “liabilities” and “shareholder equity.” 

Definition of liabilities

In this context, a liability is any money you owe someone or would owe someone if the business shuts down. This includes debts from bank loans, as well as unpaid invoices and contracts. 

For example, let’s say you own a restaurant and have a year-long lease on a building. Even if the business shuts down, rent is a liability until the lease is over. That is a liability that needs to be taken into consideration when calculating your D/E ratio. 

A comparable example for online businesses would be a software contract that must be fulfilled. 

To understand your liabilities, it’s important to look at billing cycles for your operations. How much do you owe and when?

Definition of shareholder equity

Shareholder equity is the amount of money that would be distributed to shareholders after all assets are liquified and all liabilities are subtracted. 

In the restaurant example, shareholder equity would be: 

Profits from the business + the value of resold appliances, furniture and materials - all liabilities

A comparable example in an online business would be: 

Profits from the business + the value of resold domains and other intellectual property - all liabilities

Calculating your debt-to-equity ratio

The values of “liabilities” and “shareholder equity” may vary. Subsequently, D/E ratios often fall into a range. 

For example, one person may count a full year building lease as a liability. Another may argue that because the lease can be terminated early, only a few months of the lease actually count as a liability. 

Similarly, different estimates may be given for individual assets. One person could count on the market value of resold items. Another person could argue that there is no guarantee that items would be resold, and choose to leave them off the “assets” category. 

In general, finance teams tend to lean into conservative estimates. It’s better to overestimate debts and underestimate assets than the other way around.  

But at the end of the day, what matters most is that you use consistent logic on your balance sheet. If you define something as an asset, always mark it as an asset. Use the same methodology for liabilities. 

How finance teams should interpret debt-to-equity ratio

When you’re thinking about how to measure your companies performance, your debt-to-equity ratio will land you with a deceptively simple number. 

While it’s a great metric to have, it should not be used independently. Just like any other metric, debt-to-equity ratios should be interpreted holistically. It is one data point that paints a picture of your business’s financial health when combined with other metrics and context. 

With that being said, understanding what D/E ratios signify is helpful for interpreting your data. 

Equity ratios below 2.0

It is widely accepted that an equity ratio below 2.0 is a healthy benchmark for a business. 

A D/E ratio of exactly 2.0 means that there is a 2:1 ratio of debt to shareholder equity in a business. In other words, the amount of debt is double the amount of equity. 

Keeping your D/E ratio below this benchmark typically signals that your business is taking on a reasonable amount of debt. 

But that doesn’t mean that lower is better. If your D/E ratio is still positive, but below 1.0, this means that your company has more assets than liabilities. This typically signals that the business could be growing faster by taking on strategic debt. 

In some cases, taking on too little debt can harm your business by stunting its growth potential and limiting access to capital and alternative funding options

Equity ratios above 2.0

On the other side, equity ratios above 2.0 are typically seen as risky. This D/E ratio means that a business has more than double the amount of debt as it does equity. 

For lenders, this signals that the business may not be financially capable of paying back extra debt. For businesses, this means that operations may be too reliant on borrowed money. 

It’s worth noting that your D/E ratio will vary quarter-to-quarter and year-by-year. In a quarter where strategic debt has been taken on, it is not a problem for your ratio to be a bit higher. 

It becomes an issue when the strategic debt doesn’t lead to increased profit. If your business regularly takes on debt that does not lead to profit growth, you will see your D/E ratio plateau or increase. The more consistently this happens, the more it indicates that different decisions need to be made. 

Negative equity ratios

The only way for a D/E ratio to be negative is if shareholder equity is negative. This signals that after all debts are paid, shareholders will still owe money. This indicates that the business is not profitable and may signal a risk of bankruptcy. 

Again, all businesses will see a fluctuation of D/E. A single data point does not guarantee catastrophe. But if negative D/E becomes a trend, it is time to rethink business decisions. 

Debt-to-equity ratio by industry

While there are widely-accepted benchmarks, debt-to-equity ratios vary by industry. This is because the nature of each industry is different. 

For example, agriculture is an industry that requires a lot of machinery and investment in land. According to the USDA, the debt-to-equity ratio for this industry is in the double digits, with the average being 15.7 in 2021. 

On the opposite side, the average D/E ratio for technology companies is well below 1.0. 

The best way to understand what is considered healthy for your industry is to contact your bank and ask which benchmarks they use. Even if you are not applying for a loan, knowing this number is a good indicator of where you stand in the competitive landscape. 

Debt-to-equity vs. debt-to-assets vs. debt-to-income 

These three metrics are often confused for one another, but only two are relevant for business purposes: debt-to-equity and debt-to-assets. Debt-to-income is used for personal finances, so we will not discuss it in-depth here. 

The main difference between debt-to-equity and debt-to-assets is the time horizon. Debt-to-equity measures the long term financial health of a company, while debt to assets measures short term financial health. 

If your debt-to-equity is within industry benchmarks, it means that even if you closed your business, you would be able to pay your debts and provide shareholders with a payout. Meanwhile, debt-to- assets measures what percentage of your assets are funded by borrowed money.

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FAQs
What is the difference between debt-to-equity ratio and debt-to-income ratio?

Debt-to-equity ratios are used for businesses, while debt-to-income ratio is used for individual finances. 

Is 0.5 a good debt-to-equity ratio?

While it varies by industry, anything below 2.0 is typically considered a good debt-to-equity ratio. If your ratio is below 1.0, this may signal that it is a good time to take on strategic debt for expansion efforts. 

How is debt to equity ratio calculated?

Debt to equity is calculated by taking your total liabilities and dividing them by shareholder equity. 

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