Decoding Debt‑to‑Equity Ratio: Key Metrics for Businesses

The debt-to-equity ratio is a financial performance metric used to assess your business's financial leverage — the use of borrowed money to finance operations and business investments to generate returns.

By comparing your total debt to total equity, this metric helps you understand how you finance operations and growth and the balance between borrowed funds (debt) and owned money (equity).

Ultimately, the debt-to-equity ratio tells you how much of the company's financing comes from earnings and investors versus borrowed funds in the form of loans and other types of debt, allowing you to evaluate leverage and risk.

The debt-to-equity ratio allows businesses to gauge their financial health and strategic standing in a marketplace. As a snapshot of a company's financial leverage, it compares the amount of funding that comes from debt to the funding that comes from shareholder equity, providing benefits such as:

Accesses financial health

The debt-to-equity ratio can help businesses assess their financial health and overall stability. A high ratio indicates a company might be funding too much of its operations with debt, which also indicates a high level of risk.

In this case, if a company's earnings decline, it may struggle to repay those debts. If a company chooses to finance an increase in production through debt, which leads to higher variable costs, it could increase its debt-to-equity ratio.

Conversely, a lower ratio indicates a company has been using its own funding to grow the business, which puts them in a more stable position. However, it may also mean the business isn't properly utilizing debt as a growth opportunity.

You should calculate variance – how the debt-to-equity ratio varies over time— to determine whether your use of leverage is stable and sustainable. This can help you determine if taking on new debt is a good idea or could put your business at risk.

Impacts borrowing costs and credibility

Calculating the debt-to-equity ratio can help business leaders determine borrowing costs and overall business credibility. A higher ratio might increase borrowing costs because they have a higher risk level. The opposite is true for a low ratio.

Since lending institutions might use the debt-to-equity ratio to determine creditworthiness, they may be less likely to lend to businesses already using massive amounts of debt to fund their operations.

Helps to compare companies

The debt-to-equity ratio also helps companies compare themselves in the marketplace, revealing how a company finances its operations compared to others.

Investors also use this metric to determine which businesses to invest in if they're within the same industry. If your business is looking for funding, an investor might compare your debt-to-equity ratio to your competitor's to determine which one to invest in.

How to calculate the debt-to-equity ratio

You can calculate your own debt-to-equity ratio before applying for a loan or looking for an investor by using the following formula:

Debt-to-equity ratio = company's total liabilities/ total shareholder equity

The company's total liabilities are your company's short- and long-term debt, including things like loans, bonds, and lines of credit. On the other hand, total shareholders' equity is the money returned to shareholders if the company liquidates its assets and pays its debts off.

You can calculate the total shareholder equity by subtracting the total liabilities from the total assets. You can typically find this information and other financial metrics on the company's balance sheet.

Example of debt-to-equity ratio

To help you understand how to calculate the debt-to-equity ratio of your company, let's take a look at an example. Let's say your company has a debt totaling $100,000 and shareholder equity totaling $1,000,000.

To calculate your debt-to-equity ratio, we'll just plug the numbers into the debt-to-equity ratio formula we discussed above.

Debt-to-equity ratio = $100,000/ $1,000,000 = 0.1

What this means is that for every dollar of equity that shareholders have, the business has 10 cents in debt. This is a low ratio, meaning your company is not highly leveraged and primarily uses its own money to fund opportunities and operations.

Limitations of debt-to-equity ratio

Like any financial metric used in business, the debt-to-equity ratio has limitations that should be considered. Here are some potential limitations to keep in mind:

Industry variations

Different industries have different average debt-to-equity ratios because their capital structures vary.

Industries that rely on capital, such as manufacturing and tech, may have higher debt-to-equity ratios than startups because they require significant debt to finance large-scale projects. Therefore, it doesn't make sense to compare the debt-to-equity ratio of companies in different industries.

Quality of debt

The debt-to-equity ratio doesn't take into account the quality of the debt and instead treats all debt the same. However, some debt might be more favorable than others with lower interest rates. The quality of the debt can significantly impact a company's overall risk profile.

Higher-quality debt typically has lower interest rates and longer maturity periods, making it less of a financial strain on cash flow while providing the business with more flexibility. This type of debt is less risky and can be beneficial.

On the other hand, low-quality debt with higher interest rates can increase financial risk and require more immediate cash flow.

Timing of debt

The debt-to-equity ratio of a business is just a snapshot, meaning it measures a company's financial health at any given time. However, it doesn't account for the timing of debt repayments.

A company with debt that matures faster will have a higher financial risk than a company with debt spread over a longer repayment period, even though their debt-to-equity ratios are the same.

Profitability

Higher potential for profits is often one of the main reasons businesses borrow money. However, the debt-to-equity ratio doesn't consider the potential profitability of a company. While a company might have a low ratio, it can still be unprofitable.

Meanwhile, a company with a higher ratio can have stronger profits.

A good debt-to-equity ratio depends on the industry, economy, company growth, and many other factors. Generally speaking, a debt-to-equity ratio of 1.5 or less is considered good.

A high debt-to-equity ratio indicates that a company funds its operations and growth primarily with debt, indicating a higher risk profile because they have more debt to repay. However, a high debt-to-equity ratio isn't necessarily a bad thing because it can often fuel growth when used properly.

On the other hand, a low debt-to-equity ratio indicates that a company is using primarily equity to fuel growth and fund operations, meaning they have a lower risk profile because they have fewer debts to repay. But using equity instead of debt to finance operations could mean that the company isn't taking advantage of the opportunities that come with increasing cash flow in the form of debt.

Using equity also dilutes ownership and can result in lower earnings for shareholders. For instance, if you're the only business owner and continuously invest your earnings back into the business, you're taking a much lower salary.

And remember, having a low debt-to-equity ratio doesn't necessarily mean your business is profitable. It might actually need debt to become profitable because debt will allow you to take advantage of growth opportunities you might otherwise not be able to.

So, what is a good debt-to-equity ratio? A good debt-to-equity ratio varies based on industry and individual companies. What's best for your business depends on its circumstances and whether it's planning to grow and has reliable cash flow.

Understand the debt-to-equity ratio for more financial stability

Calculating debt-to-equity ratio can help you determine whether your business should take on more debt to increase cash flow that funds growth opportunities. Businesses shouldn't be afraid of debt. When used correctly, it can fuel growth and increase investor confidence in a business by showing them you can use debt to improve business operations.

The debt-to-equity ratio is a valuable tool for businesses and investors and can show you how much your business relies on debt to help create a better business plan.

Keep in mind that in order to fuel growth, you need more than just debt and good financial habits — you need a robust marketing strategy that highlights your brand pillars and can help you capture your audience's attention. Try Mailchimp's suite of marketing tools to find new digital marketing growth opportunities.