Are you a small business owner? Maybe you’re just flirting with the idea of starting your own side hustle and want to understand your profit potential. Calculating your debt-to-equity ratio is one of the clearest ways to determine the overall health of your brand. In the simplest of terms, it helps you assess your assets as compared to your liabilities, but more importantly, gives you a gut check on the financial stability of your biz. It’s also one of the top questions you’re likely to be asked by investors. Here, we break it down.
What Is a Debt-to-Equity Ratio?
A debt-to-equity ratio—often referred to as the D/E ratio—looks at the company’s total debt (any liabilities or money owed) as compared with its total equity (the assets you actually own).
This number is designed to explain whether or not a company has the ability to repay its debts. A lower D/E ratio works in your favor—it’s a sign that you are financially stable and have internal resources should profits or the economy suddenly tank. On the flip side, a D/E ratio on the higher side (or one that is steadily rising) could be a marker to investors that your debt outweighs your company’s ability to generate its own capital or turn a profit. In other words, your business relies on debt to finance operations. This is especially concerning if your company is new.
What Is Debt?
In this case, we’re talking about any liabilities you’ve taken on to run your business. Let’s say you own a flower shop and you took out a small business loan to help cover the cost of a part-time employee and a portion of your rent. Anything that goes unpaid or that you owe money on as part of your brand (even money you borrow from a friend that you will eventually have to pay back) is considered debt.
What Is Equity?
This is the value of your company’s assets (cash, property, equipment) after you subtract any debts or liabilities. About that flower business…let’s say that you bought your storefront for $250,000, with $150,000 down. You had to take out a bank loan to cover the remaining $100,000. That makes your total debt (in regards to real estate) $100,000 and your equity $150,000 (i.e. this is the part you own, no strings attached). So in this case, the ratio is .67.
What Is a Good Debt to Equity Ratio?
To determine this, you really have to know your industry. (Investors looking into your D/E ratio should be well-versed in this as well.) For instance, the average D/E ratio for S&P 500 companies (like Lowe’s or Domino’s Pizza) is typically 1.5. But investors in financial industries can expect a D/E ratio that’s 2.0 and above. Small or service-based businesses—like that flower shop—probably want a D/E ratio that is 1.0 or lower, since they have less assets to leverage.
It’s sort of in the eye of the beholder. For instance, a high debt-to-equity ratio can be problematic if something happens (an economic downturn, for example) where you suddenly can’t pay the bills or keep up with what you owe. Conversely, a high debt-to-equity ratio can mean opportunities for rapid growth. After all, let’s say you use that debt to expand the business and start a new revenue stream (new flower delivery service, whoop!) which can have major benefits.
Keep in mind that a low debt-to-equity ratio can still be risky, and the return on investment also tends to be more moderate. Still, companies with lower debt-to-equity ratios aren’t as vulnerable to economic ups and downs and are less likely to go out of business.
How to Calculate Your Debt-to-Equity Ratio?
The best way to calculate your debt-to-equity ratio is to follow this equation:
Debt-to-equity ratio = your short-term + long-term debts / shareholders’ equity
To calculate the shareholders’ equity, you need to look at your total assets and subtract your liabilities. (Think of the $150,000 down-payment and $100,000 mortgage example.)
In Excel, you can tally up any debt (your mortgage, credit card balances or any additional lines of credit) in one column. In the column beside it, add up your total equity (property or equipment owned, retained earnings or money investors have paid in exchange for company stock, etc.). Next, divide the cell with your debts by the cell with your equity. That will help you generate your debt-to-equity ratio.
But it may be worth hiring a professional to do the math for you and make sure you really consider the range of liabilities you may have. (These range from short- and long-term loans and bonds to interest payments.) Same goes for calculating your assets, which can be nuanced at best.
Investors look to this calculation to assess how risky your business is, and this number also plays a part in your ability to borrow future funds; Banks don’t want you to become over-leveraged and often put a cap on how much they’ll lend you, based on your business’s debt-to-equity ratio.
How to Use Your Debt-to-Equity Ratio to Interpret Profitability
Bottom line: The debt-to-equity ratio is a tool business owners and investors use to assess financial obligations and potential for gain. It helps you predict risk, especially as it applies to your brand’s strategy and financial structure. If your debt-to-equity ratio is higher than 1.0, it could be a sign that you’re over-leveraged. But it could also mean that you’re on the cusp of something big. That’s up to you (and your investors) to decode.