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 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.
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.
Why It 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.
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.
If you’re thinking of applying for a loan, get started with SmartBiz Advisor today to learn where you stand in terms of being Loan Ready, based on key criteria that banks typically use to assess your business. This free, online tool will serve as an educational resource for you and provide personalized insights and recommendations to improve your situation if necessary.
* The information provided through SmartBiz Advisor, including the Loan Ready Score, is for educational purposes and is not the same as scores used by lenders for credit decisions. SmartBiz Advisor is not a financial or legal advisor as defined under federal or state law. Use of this information is not a replacement for personal, professional advice or assistance regarding your finances or credit history.