What Is Debt-to-Equity Ratio (D/E)?: Definition and Formula

Updated on March 3, 2020
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For many small business owners, scaling a business sometimes requires a little bit of outside help financially. We’re not talking about your accountant or bookkeeper helping you manage your business finances, but rather in terms of capital—whether that comes from seeking small business financing, or courting investors. (Sometimes, it could mean both.) If that’s the case for you, understanding your debt-to-equity ratio is crucial to understanding your company’s financial position.

The debt-to-equity ratio is a fairly simple measure of how much debt and equity is being used to finance your company’s assets and operations. And, yes, we do mean simple: It’s a straightforward equation known as the debt-to-equity ratio formula that you can calculate on your own. 

Once we introduce you to the purpose of this ratio, we’ll show you how to calculate debt-to-equity ratio, help you understand why it’s important, and even define what a good debt-to-equity ratio is.

What Is Debt-to-Equity Ratio?

The debt-to-equity ratio is a number that shows you how much liquidity your business has by comparing your total debt to your total equity. With this ratio, you’ll have a sense of what’s called your “financial leverage,” which shows how much of your company’s financing is coming from debt (such as creditors like small business lenders), rather than wholly owned sources, such as shareholders and investors.

A debt-to-equity ratio of 1 means that investors and creditors have an equal stake in your business. A lower debt-to-equity ratio means that investors have more stake; on the other end of things, a debt-to-equity ratio of more than 1 means that creditors have funded more than investors.

Why the Debt-to-Equity Ratio Is Important

The debt-to-equity ratio is important because it gives anyone analyzing your business’s financials a sense of whether your business is stable. Of course, your debt-to-equity ratio alone doesn’t define stability or instability, but it can hint at whether you’re borrowing too much, or whether investors don’t have a great deal of confidence in your business.

Your debt-to-equity ratio is also a kind of overall picture of how your business has been raising capital—and, perhaps, whether you’ll be able to raise more. Small business lenders and credit card companies are interested in this ratio since it’ll give them a sense of whether you’ll be able to make your debt payments.

A lower debt-to-equity ratio is generally linked to a more financially stable business. It shows that you don’t have as much debt on your balance sheet; rather, you’ve been able to secure more financing from investors, who have confidence in your operations.

A higher debt-to-equity ratio can be a little scarier to creditors (or even prospective investors), because it can signal risk. Debt has to, of course, be paid back to a lender, whether it’s a loan company or a business credit card company. That’s not the case with equity, which by definition means you’re trading a stake in your business for financing that you don’t need to repay. Obviously, debt is also more expensive (since you’re paying for it), and lenders need to see that you’re in a position to pay back any loans that they give you. Remember, the riskier you look, the less likely you are to get a loan—or, at least, one with favorable terms.

Financial Leverage, Explained

One additional thing you’ll want to understand when getting a feel for the debt-to-equity ratio is financial leverage. Leverage can be a complex corporate finance concept, but what you need to know is that this term describes how much debt you’ve used to finance your business. 

You’re considered “highly leveraged” if you’ve mostly used debt to finance your business—a financial state that’s reflected in a high debt-to-equity ratio. Highly leveraged companies may not be able to repay the debt on the books, or may seem very risky to lenders.

Debt-to-Equity Ratio Formula

If you’re wondering how to calculate your debt-to-equity ratio, the debt-to-equity ratio formula is simple:

debt-to-equity ratio = total liabilities / total equity

In other words, you’ll divide your total liabilities by your total equity. What are each of these components exactly? Let’s learn more.

Elements of the Debt-to-Equity Ratio Formula

Liabilities: The numerator of this equation are your debts. That could include your outstanding small business loans, your business credit card bills, and more.

Equity: To get the shareholders equity number, grab your balance sheet, because you’ll have to calculate it: just subtract your total liabilities from your company’s total assets.

Debt-to-Equity Ratio Formula Examples

Now, we’ll go through a couple of debt-to-equity ratio examples. After you familiarize yourself with this equation, you can plug in your business’s own numbers to get your debt-to-equity ratio.

Debt-to-Equity Ratio Example 1

For our first example, we’ll look at a fictional commercial bakery, Karen’s Kakes. They’ve just expanded into a few new markets, so they had to finance that expansion by tapping into different sources of financing: both debt and investors.

Their total liability—or debt—is $100,000. Their shareholder equity equates to $125,000. Therefore, their debt-to-equity ratio calculation looks like this:

debt-to-equity ratio = total liabilities / total equity

debt-to-equity ratio = $100,000 / $125,000

debt-to-equity ratio = 0.8

Relatively, Karen’s Kakes looks like a pretty stable business that’s not very highly leveraged.

Why is this important for Karen’s Kakes? Well, if Karen is going to try to court new investors interested in her space, these investors will want to know how confident other investors have been in her business. The answer here is pretty confident: Karen’s Kakes has raised more investment capital than they’ve put debt onto their balance sheets. 

Similarly, if Karen goes to a lender to borrow more capital—whether that’s a term loan, business line of credit, or even ask for a higher business credit card limit—lenders will have more confidence that she’ll be able to repay the capital she’s borrowing.

Debt-to-Equity Ratio Example 2

Jeff’s Junkyard is in a different position than Karen’s Kakes. They’ve needed to borrow money to invest in buying a couple of competitive junkyards—which has been good for their business, but has definitely cost a lot of money. Unlike Karen, Jeff hasn’t been able to court nearly as much investment.

Their total debt is $250,000. Their shareholder equity is $50,000. Therefore, their debt-to-equity ratio calculation is as follows:

debt-to-equity ratio = total liabilities / total equity

debt-to-equity ratio = $250,000 / $50,000

debt-to-equity ratio = 5

In this case, Jeff’s Junkyard is a highly leveraged business.

A debt-to-equity ratio of 5 is a big red flag for investors, who will see that Jeff’s financial position is pretty precarious. He simply doesn’t have the investment coming into the business to even out the liability on his books. That may make paying for his current debt very difficult, and can signal tough times ahead. 

Additionally, if he tries to seek out small business financing in addition to his other debts, he may not be approved—or may have to pay very high fees in order to compensate for his high perceived risk. And although this debt-to-equity ratio may not totally turn off investors who are comfortable taking on risk, other investors who want to see that there’s a lot of confidence around this business will likely feel that Jeff’s current financials aren’t favorable for investment.

What Is a Good Debt-to-Equity Ratio?

A good debt-to-equity ratio debt depends on your industry. In general, you’ll hope to keep your debt-to-equity ratio around 1 to 1.5, though if you’re in a highly capital-intensive industry, that ratio may creep up a bit higher without raising red flags.

Debt-to-Equity Ratio of 0

Is a debt-to-equity ratio of 0 possible? Yes, it certainly is. That can happen when you have no debt on your balance sheet, and more than zero investment capital. This is, theoretically, an incredible financial position to be in—but most business owners aren’t. Don’t feel bad if you have some debt on your books, just keep your debt-to-equity ratio from creeping up.

How to Change Your Debt-to-Equity Ratio

If you’re dissatisfied with your debt-to-equity ratio, you can change it for the better by either lessening your debts or increasing your equity investments. It sounds simple, and, conceptually, it is—but as a small business owner, you know that taking debt off your books or courting investment is easier said than done. 

Still, if you know you’re going to be looking to apply for capital, or try to raise investment capital, aiming to move your debt-to-equity ratio can be very helpful for both of these down the line.

Understanding the Debt-to-Equity Ratio of Your Business

An important thing to know is that a high debt-to-equity ratio isn’t the end of the world. In many cases, businesses have to take on a bit of debt in order to kickstart growth and start generating the revenue that will enable them to pay for their debt, grow, and attract investors.

Also, remember that you don’t need to be applying for small business capital or seeking investment to calculate or care about your debt-to-equity ratio. Among other financial ratios, understanding your debt-to-equity ratio can give you a good sense of goals you need to set for your business, and the direction you want to move. And you never know—sometimes you have to seek capital in an emergency, so being prepared with strong business financials can benefit you in the long run.

Meredith Wood

Meredith Wood is the founding editor of the Fundera Ledger and a vice president at Fundera. She launched the Fundera Ledger in 2014 and has specialized in financial advice for small business owners for almost a decade. Meredith is frequently sought out for her expertise in small business lending. She is a monthly columnist for AllBusiness, and her advice has appeared in the SBA, SCORE, Yahoo, Amex OPEN Forum, Fox Business, American Banker, Small Business Trends, MyCorporation, Small Biz Daily, StartupNation, and more. Email: meredith@fundera.com.
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