Knowing your debt-to-equity ratio is important because it shows how much your business relies on borrowed money relative to the amount originally invested by owners and the earnings retained since inception. Try the debt-to-equity calculator at the top of this page to compute your ratio.
What you’ll learn
What you’ll learn
Updated: December 10, 2024
Understanding the debt-to-equity ratio
To understand why debt-to-equity is an important metric for business owners to be familiar with, we spoke with Tom Brock, a licensed CPA and CFA Charterholder with over a decade of experience helping small businesses.
What does the debt-to-equity ratio mean?
The debt-to-equity ratio is a financial ratio that indicates the extent to which a business utilizes debt, which is also referred to as leverage, to finance its operations. It measures a company’s total liabilities relative to the amount originally invested by the owners and the earnings retained since inception.
— Tom Brock, CPA, CFA
Understanding the debt-to-equity ratio
Why should I care about my debt-to-equity ratio?
Monitoring and managing your debt-to-equity ratio can help you optimize your business’ capital structure (debt vs. equity financing) and enhance the return on investment available to owners. Paying close attention to this metric can also help you expand your funding opportunities and avoid regulatory scrutiny.
How do you calculate a company’s debt-to-equity ratio?
This key leverage ratio is calculated as follows:
- Debt-to-equity Ratio = Total Liabilities ÷ Shareholders’ Equity
What makes up liabilities and equity?
The components of total liabilities are as follows:
- Short-term debt – This category includes all interest-bearing debt obligations due within the coming 12-month period.
- Long-term debt – This category includes all interest-bearing debt obligations due beyond the coming 12-month period.
- Accounts payable – This broad category includes all the money due to a business’ suppliers and service providers.
- Accrued expenses – This category includes amounts incurred but not yet paid. Common examples include accrued salaries and accrued insurance premiums.
- Other obligations – This catch-all category includes all liabilities not distinctly identified above.
The typical components of shareholders’ equity are as follows:
- Contributed equity – This category reflects the par value of the equity invested by shareholders.
- Additional paid-in capital – This category reflects the money in excess of par value invested by shareholders.
- Retained earnings – This category reflects the accumulation of earnings retained by a business since inception.
- Dividends (or distributions of capital) – This category reflects the total amount of money that has been distributed to shareholders by a business since inception.
Interpreting debt-to-equity ratio
What is a good debt-to-equity ratio for a small business?
There is no hard-and-fast “good” debt-to-equity ratio. This metric can vary widely, depending on the industry and geographic location of focus. Generally, a sound debt-to-equity ratio for small businesses ranges from 0.5 to 1.0. This means that for every dollar invested in a company, 33% to 50% comes from debt financing and 67% to 50% comes from equity financing.
What is a bad debt to equity for a small business?
In most small business scenarios, a debt-to-equity ratio above 3.0 is highly concerning. This means that for every dollar invested in a company, 75% comes from debt financing and a mere 25% comes from equity financing.
A temporary rise to 3.0 or higher could be fine. Perhaps, it reflects an investment in a major project to improve business operations. However, running with a debt-to-ratio of 3.0 or higher for a sustained period of time is very risky.
Why is a high debt-to-equity ratio bad?
A high debt-to-equity ratio indicates a company aggressively utilizes leverage to finance its operations. In good economic times, this may be fine – as robust cash flows facilitate the comfortable servicing of debt and generation of above-average profits.
However, in bad times, excessive utilization of leverage can be disastrous. Recessionary environments inevitably result in flagging cash flows, which can lead to debt servicing issues and business failure.
For good measure, regularly monitor your company’s debt-to-equity ratio and compare it to industry benchmarks. Endeavoring not to drift too far from industry norms can help ensure your company maintains a healthy balance between debt and equity.
How can a business improve its debt-to-equity ratio
At a high level, a business can improve its debt-to-equity ratio by either reducing its total liabilities or increasing its shareholders’ equity. The most immediate way to drive the ratio lower is to pay down debt with excess cash or via an injection of owners’ equity. A longer-term way to drive the ratio lower is to generate consistent profits and grow owners’ equity via the accumulation of retained earnings.
More details on debt-to-equity
What are the common pitfalls when calculating debt-to-equity ratio?
The debt-to-equity ratio is a very straightforward metric to compute. All you need to do is review your company’s balance sheet and pinpoint two prominently reported figures – total liabilities and shareholders’ equity. The debt-to-equity ratio is calculated by dividing total liabilities by shareholders’ equity.
If you do not periodically generate a balance sheet, which is also referred to as the statement of financial position, I suggest you start doing so as soon as possible. Perhaps, this means enlisting the help of a financial professional, such as a CPA or an experienced bookkeeper.
How does the debt-to-equity ratio impact a company’s financial health?
Understanding your company’s debt-to-equity ratio is essential to make prudent business decisions. Periodically assessing it yields insights into your company’s financial health, risk profile and debt capacity, all of which can help you navigate the ever-changing business landscape and position you for long-term success.
In general, an elevated debt-to-equity ratio signifies a company is financially distressed and on the brink of insolvency, which means it is unable to meet its debt obligations. However, a very low debt-to-equity is not necessarily a positive sign, as the company may be relying too heavily on equity financing, which is much costlier than debt. This can limit growth opportunities and depress investment returns for your business’ owners.
How often should a small business owner recalculate the debt-to-equity ratio?
A small business owner should calculate the debt-to-equity ratio each financial statement closing cycle – along with the distribution of a full set of financial statements. Ideally, this takes place on a monthly basis. However, for some businesses, a quarterly closing cycle is adequate.