Calculating the debt-to-equity ratio of your business can be a useful exercise to determine whether your company is an attractive investment opportunity. This is why we've compiled this short guide to what the debt-to-equity ratio is and how to calculate it.
Debt-to-equity ratio - explained
A company's debt-to-equity ratio refers to the proportion of debt to equity used to finance a company's assets. It determines what percentage of the company is funded by debt that needs to be paid versus wholly-owned. It can help you understand whether your shareholders' equity would be enough to cover debt financing in the case of a decline in business. As a small business, calculating debt ratio and equity ratio can inform a good understanding of how viable your financial modelling is.
However, there are limitations to calculating the debt-to-equity ratio. The ratio of debt financing to equity financing can differ greatly in different industries, as it might be more usual in one industry to rely on more debt financing, while another industry has a debt-to-equity ratio which can distort the picture. Businesses in sectors with higher capital expenses tend to take our more long term debt and eg bank loans. This is why these financial ratios are best used to compare your company against competitors rather than across sectors.
How to calculate your debt-to-equity ratio
The formula for debt-to-equity ratio analysis is as follows: Debt-to-equity ratio = Total Liabilities / Total Shareholder Equity.
Company A has liabilities of GPB 300,000 and total equity of GPB 150,000. Using the formula above, the calculation is as follows: Debt-to-equity ratio = 300,000 / 150,000 = 12.
Company A has GPB 2 of debt for every GPB 1 of equity.
With the ratio of total debt to total equity, it is key to not go too high or low - if your rate is too high, your company might not be able to pay its debt obligations. However, if your rate is too low, your business could be too reliant on equity which can slow down your business and tends to be costly. A good ratio depends on the sector or industry your company is in - eg organizations in the manufacturing industry should aim for a ratio of c. 2-5. Companies in a more service-focused industry should aim for a ratio of 2 or below.
Improving your business's debt-to-equity ratio
If your debt-to-equity ratio is too high, there are a few things you can do. Your main priority should be to increase revenue. This then helps you pay back debt or obtain new assets, thereby keeping your debt-to-equity ratio stable. Also, ensure you do not waste any assets on eg inefficient inventory management.