Last Updated on February 3, 2021 by Grey Idol
When it comes to figuring your ability to secure funding for your business, you need to have a clear idea of your financial situation. There are many ways to do this.
You must start by gathering all your financial data. You can then use several formulas to assess your current standings. One of those formulas is the debt-to-equity ratio.
The ratio can give you some guidance, but it isn’t a complete picture. It’s crucial if you calculate this ratio that you understand how to use it to benefit from it properly.
What Is the Debt-to-Equity Ratio?
The debt-to-equity ratio tells you the relationship between your business debts and the equity your shareholders have. Ohio University explains that you create the ratio from information on your balance sheet or market values.
It tells you how much of your company your investors own. Essentially, if you were to go out of business at this point, it reveals to you how much you would have left over after paying out the equity others hold.
Debt-to-Equity Ratio Formula
To calculate the debt-to-equity ratio, you use this formula:
Debt-to-Equity Ratio = Debt/Equity
Or, in words, the debt-to-equity ratio is equal to debt divided by equity.
For debt, you want to use the total for the debts of your company. Consider everything you would need to pay off if you went out of business. For the equity, you need to use the total equity.
You should be able to get the figure you need from your balance sheet. However, you may need to take time to figure out what debt actually means.
Entrepreneur explains that debt may or may not include all liabilities. Another way to figure this is using only long-term debt. If you want the truest ratio, though, you should use all debts you must pay at their current rates. Keep in mind that due to interest and other adjustments, your debt-to-equity ratio will change every day.
Here’s the ratio in a practical example:
- Debt: $100,000
- Equity: $20,000
- Debt-to-equity ratio: 5
You would divide the debt by the equity to get your ratio.
How to Use the Debt-to-Equity Ratio
The debt-to-equity ratio can provide you a look at the overall stability and financial health of your business. Increasing ratios indicate that you have increasing debt. When your debt is too high, it reduces the cash flow within your business. This shows a troubling trend in your industry that requires correction to avoid financial issues in the future.
The debt-to-equity ratio can also tell others about your business. Lenders will often use the ratio in making decisions about providing you with funds.
You should note that creditors will often use this ratio to assess your business’ creditworthiness. They may set a limit, and if your ratio figures out to be over that limit, the creditor won’t allow you to borrow money.
The idea here is that your debt-to-equity ratio will tell the creditor how much debt you have. If you have too much debt, then you should try to protect your investors by not allowing the business to get further into debt. Lenders may also assess things this way, especially if you already owe that lender money from previous transactions.
Limitations of the Debt-to-Equity Ratio
While the debt-to-equity ratio can give you an excellent snapshot of your current financial situation, it does have its limitations. Zacks explains that this ratio is a good starting point, but it requires a further inquiry to get the whole truth. For this reason, lenders won’t rely solely on this ratio.
Figuring the Ratio
It is difficult to compare the debt-to-equity ratio of two companies because accounting processes can vary, which will distort the ratio. Liabilities and assets can have different records that compute to different amounts used for the formula.
To make use of this ratio, you would have to understand how the person is preparing the ratio computed debt. You will want to know which debts the person used and how they figured the debt value. It is almost effortless to manipulate the numbers to get a more favorable ratio, which will not be an honest ratio. If you want to get an accurate idea of where your business stands, you need to commit to using the truest figures.
In general, a high debt ratio will tell you that you have too much debt. However, if the figures are not correct, then your interpretation will not be accurate.
There may be other factors that influence your overall financial health, yet don’t factor into this ratio at all. For instance, your company may have a high ratio, but your company may not be in the wrong place due to other lucky factors. Another example would be if you recently made a major investment, and your debts may be high, but the investment may pay off once things even out.
Keep in mind that a debt-to-equity ratio is just a minute snapshot. It can change rapidly. You don’t want to rely on the ratio for an extended period because it won’t remain accurate.
The Ideal Debt-to-Equity Ratio
Because of the many variances in debt-to-equity ratios, there isn’t a standard ideal ratio you want to aim for. However, some general guidelines will help you know how your business is doing based on your debt-to-equity ratio.
SmartAsset explains that ideally, you want a low debt-to-equity ratio. What is low can vary from industry to industry. Therefore, you cannot compare your ratio to a company in another industry because they won’t match up. A four could be acceptable in your industry, but in another sector, that may be high.
For many industries, a low, single-digit ratio is ideal. However, in other industries, such as the financial sector, a ratio in the 20s belongs to the spectrum’s unideal side. It is about how much debt is acceptable in your industry.
While it is always ideal to have a lower ratio, some industries may be fine with a higher ratio because achieving a low one is not feasible. If you are in an industry where high debt is a normal occurrence, then a high ratio is probably not unheard of. However, if your industry looks down on debt, you want your ratio to be as low as possible.
However, you don’t want your ratio to be too low. There is such a thing as too low because it signals that you are not investing in your business when your ratio is suspiciously low. It tells people that you are trying to grow your business and that you’ve become stagnant.
If you find yourself with a low ratio, you may also begin getting acquisition offers. Investors will see this as a sign that your business is at its natural end with where you can take it. You may even start to lose investor confidence.
The key here is finding what is typical for your industry. All industries have average debt-to-equity ratios. You want to see yours and make sure you are on par with your competitors. This is far better of an indication of your business’ financial health than merely looking at your ratio alone.
The debt-to-equity ratio can be an excellent tool for figuring out your business’s financial health, but it is not a complete picture of the situation. You need to understand the limitations of this ratio and how it can skew your finances’ reality.
Besides, you must understand that the ratio may mean different things in different industries. It is not enough to say a low number is ideal because it is even possible to go too low. The bottom line here is that you need to find the perfect ratio for your industry and aim for that.