Debt-to-Equity Ratio Explained

The Importance of the Debt-to-Equity Ratio

Staying on top of financial leverage, risk, and borrowing capacity is an ongoing challenge for business leaders. The debt-to-equity ratio is a simple way to understand how your business funds its operations.

Today, we’ll look at what the debt-to-equity ratio is, how to calculate it, how to interpret it by context and industry, and what to watch for when the number is unusually high, low, or negative.

What Is the Debt-to-Equity Ratio, and What Does It Measure?

The debt-to-equity ratio divides your total liabilities by your shareholders’ equity, telling you how much of your business you’re financing with debt instead of your own resources.

This means the debt-to-equity ratio provides a good picture of solvency, predicting whether you’ll be in business for the long term—a particularly important piece of information for external organizations (e.g., banks, lending institutions, analysts, and shareholders) to have.

But debt-to-equity ratio is not a one-size-fits-all financial metric. It should only be used to compare your company with direct competitors or monitor your long-term debt reliance. And, while it is typically rated as good/bad or high/low, the reality is more nuanced. What the numbers mean for your business can vary depending on several factors, including your industry.

What is Equity in Finance, and What Counts as Equity on a Balance Sheet?

In finance, equity describes how much an asset or investment would be worth if liquidated, minus any debt. For shareholders who have contributed capital to a business, shareholder equity represents the value of their investment after liabilities are considered. Or, to put it another way, it represents the company’s net worth.

Shareholders have a big stake in how financially healthy your business is, up to and including keeping an eye on their dividends and your retained earnings (or the cumulative net income you retain after paying obligations and expenses—like dividends—and reinvest into your business for growth and financial stability.) Retained earnings are found in the shareholders’ equity section of your balance sheet.

Your balance sheet will show your total shareholders’ equity. That equity is determined by accounting for your total assets (e.g., cash and cash equivalents, accounts receivable, inventory, etc.) and subtracting your total liabilities (e.g., accounts payable, credit lines, deferred revenue, long-term debt, etc.).

Equity vs. Debt: How They Differ in Business Decision-Making

Debt and equity are the two main methods of raising capital for a business. In debt financing, you borrow funds and pay them back with interest, and, in equity financing, you sell shares in your business.

The financing method you choose depends on your projected business performance. If you expect to perform well, then obtaining debt financing may be the way to go. You would have a fixed interest rate (keeping in mind that this is a fixed expense that can increase your risk rating) and a tax benefit (because the interest paid on business loans is often tax deductible). In contrast, equity financing requires you to sell a percent stake in your business. This ensures no debt, but your profit will be shared by the shareholders.

According to Investopedia, your company’s age and the industry in which you operate are key barometers for deciding which financing method makes the most sense. “The more uncertain a company’s future earnings, the higher the risk. Companies that are either in risky industries or small and just starting up are less likely to use debt financing than companies in stable industries with consistent cash flows. New businesses with high uncertainty are more likely to use equity financing because they may have a difficult time obtaining debt financing.”

Debt-to-Equity Formula

To calculate your debt-to-equity ratio, use the following formula:

Debt-to-Equity Ratio = Total Liabilities ÷ Total Shareholders’ Equity

Let’s look at an example. If Company C has $400,000 in total liabilities and $325,000 in shareholders’ equity, then its debt-to-equity ratio is 1.1 (or 1.14 for use in more detailed analyses).

It’s important to note here that some analysts will calculate the debt-to-equity ratio using net debt, which is total liabilities minus cash and cash equivalents, as the numerator to show a company’s ability to pay down its debt. For the denominator, others will use market value of equity (which reflects the current valuation of a company in the open market) instead of total shareholders’ equity.

What Does the Debt-to-Equity Ratio Tell You in Practice?

The debt-to-equity ratio is a critical signal providing valuable information about the health and potential of your business.

For example, it sends you risk signals. A high ratio indicates that a company is relying heavily on debt and creditors, which leaves it vulnerable to financial challenges, such as higher interest rates (which increase expenses and reduce income) and the inability to invest in expansion efforts.

The debt-to-equity ratio also indicates how well you’re managing your finances over time. It shows whether you’re gaining or losing equity in comparison to your debt load, which provides insight into how you should move forward.

What Good, Bad, and Negative Debt-to-Equity Ratios Mean

Going back to our debt-to-equity ratio calculation example, Company C has a debt-to-equity ratio of 1.1. Is this good or bad? It depends.

Typically, the lower the ratio, the better. This suggests that the company is making judicious use of its capital and balancing its debt and equity well, ensuring that its debts can be paid off and that it has enough money to wisely invest in company growth. A higher ratio may tell investors and analysts that you’re relying on debt rather than equity to grow.

There are times, however, when too low a ratio can cause concern and when too high (approximately 1.5 or higher) isn’t concerning at all.

Here are some factors to consider when interpreting your debt-to-equity ratio:

• Your industry: Some industries naturally operate with a higher debt-to-equity ratio due to investments in equipment and infrastructure (e.g., manufacturing and utilities). Financial institutions and airlines also have higher ratios because of their fixed assets (e.g., branch networks for banks and expensive aircraft and infrastructure for airlines). Other industries, like services and software, can get up and running with fewer resources, thus requiring less capital.
• Your growth stage: If you’re just starting your company, you’ll need capital before you can grow your equity. This will skew your ratio high. The same holds true for companies that are investing in expansion initiatives. In these situations, the high ratio is temporary.
• Your competition: Comparing your debt-to-equity ratio to companies that aren’t direct competitors will not provide an accurate picture. A high ratio may be “normal” for your industry, and where you land in relation to that industry average will signal if you’re overleveraged, balanced, or underleveraged.

Speaking of underleveraged, having too low a ratio suggests you may be missing out on the advantages that come with debt financing, such as tax benefits and growth potential. And a negative ratio, which is when you have more liabilities than assets, is a financial SOS, marking you as high risk for bankruptcy and/or insolvency.

Long-Term Debt-to-Equity vs. Total Debt-to-Equity: Which Should You Use?

The information you use to calculate the debt-to-equity ratio can change its meaning.

For instance, the total debt-to-equity ratio is calculated as described above, but what if you want to know how long-term debt is affecting your financial health?

While short-term debt must be paid within one year of disbursement, long-term debt is due to be paid off in, typically, five to 30 years. Examples include bonds, mortgages, bank loans, and pension obligations. Long-term debt is riskier than short-term debt because it is subject to potential interest rate spikes and refinancing requirements. The long-term debt-to-equity ratio removes short-term debt from the equation as follows:

Long-Term Debt-to-Equity Ratio = Long-Term Debt ÷ Shareholder Equity

Assuming your business will be fully operational in the next year, you’ll be able to pay off your short-term debt, but meeting your long-term debt requirements is less certain. Measuring your long-term debt-to-equity ratio can reveal what steps you need to take to ensure you remain solvent now and in the future.

Limitations: What the Debt-to-Equity Ratio Misses

Financial health is, of course, key to your success, and, while knowing your debt-to-equity ratio certainly helps, it does have its limitations.

The debt-to-equity ratio is not consistent across industries, and knowing its accuracy requires comparison to direct competitors. Investopedia says analysts may define debt in different ways, which can produce inconsistent ratios. The ratio also doesn’t consider cash flow—missing a key indicator of a company’s ability to manage debt. And it only reflects a single point in time, which means it doesn’t include changing seasons or financial conditions.

To circumvent these limitations and more accurately measure your leverage, you can add in other financial metrics, including the debt-to-capital ratio. This ratio is calculated as:

Debt-to-Capital Ratio = Total Debt ÷ (Total Debt + Shareholders’ Equity)

It provides a picture of your debt in proportion to your entire capital structure.

Debt vs. Equity: Making Sure You Win

Ultimately, the debt-to-equity ratio offers you a clear but somewhat temporary indication of your company’s financial leverage and risk profile.

By regularly calculating your debt-to-equity ratio, you’ll know whether you’re relying too much on debt and not enough on equity or vice versa. Too much debt is risky but too little debt can imply that you’re not taking advantage of its benefits, including using it to grow your business and satisfy your shareholders.

Knowing your debt-to-equity ratio empowers you to make smarter decisions and support scalable growth, and with Acumatica’s cloud-based ERP solution, you have the unified data visibility needed to easily calculate and monitor this critical financial metric. Reach out to our team today to schedule a demo or ask any questions about managing your finances with a comprehensive ERP solution.