Even though you can find your company’s debt on its balance sheet, putting those numbers in perspective can help lenders and other institutions evaluating your business to get an overall picture of its financial health. That’s where the debt-to-equity ratio comes in.
What Is Business Debt?
Business debt is any money an entity has given you to fund your operations that you must repay. SBA loans, credit card bills, merchant cash advances, bank term loans, and similar business funding avenues comprise your business debt. Generally, monthly payments on equipment loans or other tools are not considered debt, as the parties you pay for these items haven’t given you liquid cash for your business.
What Is Equity?
Equity is the difference between the cash value of all your assets (including but not limited to patents, inventory, and commercial real estate) and the debts you owe. It represents the maximum potential value that you could divide among your shareholders if you liquidated all your assets and paid off all your liabilities.
What is the Debt to Equity Ratio?
The debt-to-equity ratio (D/E) is a measurement used for determining the proportion of net value to business debt . Also known as the gearing ratio, the metric reveals the financial leverage of the company, which is the difference between the amount the owner can cover and the borrowed funds.
How to Calculate Debt-to-Equity
The calculation for the debt-to-equity ratio is total debt divided by total equity. Equity refers to the company’s assets after its debts and liabilities have been taken care of.
Expressed as a formula, the debt-to-equity ratio is:
D/E = total debts/total equity
You can also write this formula as:
D/E = total business liabilities/total shareholder equity
And since shareholder equity is the difference between assets and liabilities, you can also write the debt-to-equity formula in the form below:
D/E = total business liabilities/(total business assets - total business liabilities)
You may find the above formula significantly easier to use than the two preceding it if you don’t have your most recent balance sheet handy. That’s because assets and liabilities are generally easier to quickly tally or at least estimate than shareholder equity. That said, all three quantities are indeed readily available from your balance sheet, as the below real-life example shows.
Examples of Debt-to-Equity
To understand the debt-to-equity ratio, you may find a real-life example helpful. To that end, the below example uses Amazon’s real-life balance sheet and its asset, debt and equity data for several debt-to-equity ratio calculations.
Amazon’s December 31, 2020 balance sheet indicates $321,195,000 in total assets, $227,791,000 in total liabilities, and $93,404,000 in total equity. (Note that the sum of these liability and equity values is the total assets.) Given these figures, Amazon’s debt-to-equity ratio is:
D/E = total debts/total equity = $227,791,000/$93,404,000 = 2.44
You’ll get the same number using only assets and liabilities:
D/E = $227,791,000/($321,195,000 - $227,791,000) = 2.44
It’s also worth calculating Amazon’s debt-to-equity ratio for 2019, 2018, and 2017 to show how a major company’s debt-to-equity ratio may change over time. Using the data from Amazon’s balance sheet, you’ll calculate the below debt-to-equity values:
D/E (2019) = $163,188,000/$62,060,000 = 2.63
D/E (2018) = $119,099,000/$43,549,000 = 2.73
D/E (2017) = $103,601,000/$27,709,000 = 3.74
As you can see, Amazon had a much higher debt-to-equity ratio in 2017 than in 2020, and the company’s ratio decreases over time. The meaning that investors and financiers ascribe to this ratio can help explain these changes.
Why The Debt-to-Equity Ratio Matters
Some lenders may consider calculating the debt-to-equity ratio because it reveals how focused the company has been on fueling growth by taking on debt. When compared to the value of its net worth, the amount of debt a firm takes on demonstrates how much risk is at stake. With a significant amount of debt, the business can generate revenue through more activity but may also fall behind on payments if the balance between costs and profits is tipped too far.
On the other hand, a lower D/E ratio indicates to lenders and investors that there’s an available safety cushion in case the firm starts falling behind on debt payments. Fall too low, however, and the ratio will indicate that the business is not taking full advantage of its available resources.
Ideally, the D/E should neither be too high nor too low to demonstrate that the company is growing sustainably.
Benefits of a High Debt-to-Equity Ratio
Among the reasons a high debt-to-equity ratio could benefit your business include:
- Trustworthy borrowing . When you hear the term “debt to equity,” you might think that lower values are better since debt is often undesirable. However, a high debt-to-equity ratio can indicate to financiers that your company is seeing a high return on equity. Put another way, if your assets are fixed and your debt increases, your equity decreases, leaving your company with more cash flow to cover its debts.
- More valuable company . Often, debt costs less than equity does, so a high debt-to-equity ratio could signify that your business has relatively few expenses. By extension, increasing your debt-to-equity ratio somewhat (though not too much) can lower your small business’s weighted average cost of capital (WACC). The lower your company’s WACC, the higher its present net value.
Disadvantages of a High Debt to Equity Ratio
Interestingly, some of the disadvantages of a high debt-to-equity ratio represent extreme versions of the above advantages. For example, a high debt-to-equity ratio can indicate:
- A company’s inability to repay its debts . Past a certain point, a high debt-to-equity ratio can signal that a company doesn’t have the money to repay its debts. Think about it like this: If your company has $5,000 in debts and $1,000 in equity, you have $6,000 in assets and a D/E ratio of 5. Assuming that cash comprises only a part of your assets, you probably don’t have enough money to cover your debts.
- Lower share prices . As mentioned above, within certain limits, higher debt-to-equity ratios lead to lower WACC values and thus a more valuable company. However, in the case of a business with $5,000 in debts and $1,000 in equity, the cost of the company’s debts is nearly the same as the value of its assets. The result is a higher WACC and thus a lower present net value. In turn, each share in your company will be less valuable.
What Is The Ideal Debt-to-Equity Ratio?
Every industry has a different ideal debt-to-equity ratio. That said, most small business finance experts recommend not exceeding a D/E ratio of 2.0. However, as shown earlier, Amazon’s D/E ratio is consistently well above this value, and the company continues to dominate the e-commerce space. Additionally, for lending purposes, you can often have a far higher debt-to-equity ratio than 2.0 and still qualify for new funding.
Debt to Equity and the SBA
In terms of SBA loans, the debt-to-equity ratio comes into play in a slightly different sense. The Small Business Administration’s Loan Fact Sheet mentions the ratio as a metric to evaluate whether the business owner has invested enough of his or her own capital in the business to cover the monthly loan payments:
“The after-the-loan business balance sheet should show no more than four dollars of total debt for each dollar of net worth (i.e., a 4:1 Debt/Equity ratio - may vary by industry).”
In this case, equity is defined as the owner’s net investment in the business.
Important Aspects and Limitations
The main limitation to keep in mind is that there’s no single “good” debt-to-equity ratio. In order to truly evaluate your business, you’ll need to consider the D/E ratio relative to the industry standard for your particular business. Using the ratio to compare businesses from different industries won’t give an accurate picture of business growth.
Another key point is that there may be different ways to calculate the ratio depending on whether or not you incorporate certain types of debt into the numerator of the equation. Make sure you know exactly what counts as a liability for your desired loan type and incorporate other metrics like debt coverage, revenue trends, and credit scores to get a well-rounded understanding of your business’s financial health.