How to Calculate Your Debt-To-Equity Ratio

Business owners often get swept up in their day-to-day responsibilities, but meeting long-term goals also requires financial planning. One of the most important aspects of your business for you to analyze is its capital structure, which refers to the mix of debt and equity used to finance its operations.



The debt-to-equity ratio can provide insight into the health of your business’ financing arrangements. Here’s what you need to know to calculate it and incorporate it into your business decisions.





What Is The Debt-To-Equity Ratio?



The debt-to-equity is a financial metric that compares a business’ liabilities to its equity. It’s one of the most frequently used gearing ratios (i.e., metrics that help assess the health of a company’s capital structure).



More specifically, calculating the debt-to-equity ratio helps determine how heavily your business relies on debt for financing. That’s a critical consideration for stakeholders because debt is generally cheaper than equity, but you can only take on so much before you start struggling to meet your obligations.



For example, business owners might calculate their debt-to-equity ratio when considering how best to fund their next project. Similarly, lenders might use it to determine whether or not to give a prospective borrower a loan.








Debt-To-Equity Ratio Formula



The formula for the debt-to-equity ratio is as follows: 



Debt-to-Equity Ratio = Liabilities ÷ Equity



Your company’s liabilities refer to the amounts it owes to other parties. That includes the various forms of business debt used to finance your operations, such as installment loans, revolving lines of credit, and accounts payable.



However, since the primary purpose of the debt-to-equity ratio is to provide insight into the distribution of financing arrangements used to finance your operations, it sometimes excludes short-term debts due in the next year (Ex: accounts payable) when calculating the ratio.



Assuming you’ve already created your financial statements, you can find both amounts on your balance sheet .



Meanwhile, your business’ equity refers to the financing it’s received through contributions from the original owners and any investors, plus any profits left in the company from previous years that you didn’t distribute back to them. It also represents what would be left if you sold all your assets and paid off your liabilities.








How To Calculate The Debt-To-Equity Ratio



Let’s run through a practical example to demonstrate how you’d calculate the debt-to-equity ratio using the information in your company’s financial statements. Say that you own a small business with the following balance sheet.



Example Business, Inc. Balance Sheet December 31, 2020 ASSETS 12/31/20 Current Assets   Cash $ 30,000.00   Accounts Receivable 8,500.00   Inventory 35,000.00   Prepaid rent 7,000.00       Total Current Assets 80,500.00 Property, Plant, and Equipment   Land 100,000.00   Building 155,000.00   Equipment 25,000.00   Accumulated Depreciation (85,000.00)       Total Property, Plant, and Equipment 195,000.00 Intangible Assets   Goodwill 75,000.00       Total Intangible Assets 75,000.00 Total Assets $ 350,500.00 LIABILITIES AND OWNER’S EQUITY Current Liabilities   Accounts Payable $ 10,000.00   Current Portion of Long-Term Debt 20,000.00   Unearned Revenues 12,000.00       Total Current Liabilities 42,000.00 Long-Term Liabilities   Notes Payable 48,000.00   Business Loan 90,000.00       Total Long-Term Liabilities 138,000.00 Total Liabilities 180,000.00 Owner’s Equity   Contributions 25,000.00   Retained Earnings 145,500.00       Total Owner’s Equity 170,500.00 Total Liabilities and Owner’s Equity $ 350,500.00



Assuming you want to include all your business debts in your debt-to-equity ratio, you’d pull the $180,000 total liabilities and the $170,500 in owner’s equity directly from the balance sheet. As a result, your debt-to-equity calculation would be the following:



$180,000 liabilities ÷ $170,500 owner’s equity = 1.06 debt-to-equity ratio








Interpreting Your Debt-To-Equity Ratio



A debt-to-equity ratio of one or less is typically considered low-risk, since it indicates you have more equity than debt. Conversely, a debt-to-equity ratio greater than one indicates that your company has more debt than equity, which can be concerning the closer it gets to two.



That said, the ideal ratio can vary significantly by your industry. Some businesses consistently have higher debt-to-equity ratios without issue, due to the nature of their products and services.



For example, utility companies usually need to expend significant amounts of capital to build the infrastructure necessary to start offering services. However, that’s typically a manageable risk due to the industry’s uniquely stable demand as an essential service.



In addition to the industry, you should consider a business’ other circumstances when assessing the debt-to-equity ratio, such as its profitability and long-term growth prospects. For example, a company with a high debt-to-equity ratio can still be healthy if it has strong cash flows. 



Ultimately, the debt-to-equity ratio is an insightful lens into the strength of a company’s capital structure. However, you must consider it in context with other financial metrics to get an accurate picture of the business’ financial health.







Information provided on this blog is for educational purposes only , and is not intended to be business, legal, tax, or accounting advice. The views and opinions expressed in this blog are those of the authors and do not necessarily reflect the official policy or position of Lendio. While Lendio strivers to keep its content up to-date, it is only accurate as of the date posted. Offers or trends may expire, or may no longer be relevant.



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