Equity and debt are two of the primary methods that businesses use to raise capital. While you likely can’t avoid debt completely, keeping debt in check is a good way to demonstrate the financial health of your organization to potential investors. Your debt-to-equity ratio can summarize your company’s level of liabilities when compared to its ability to pay off debt.
If you understand the components of this financial measurement, you’ll be better prepared to talk with potential investors about why your business is making smart financial decisions.
What is a debt-to-equity ratio?
Your business’s debt to equity ratio (D/E ratio) is a financial ratio that shows the proportion of debt and equity you are using to finance your company. This number can be relatively low or high:
- A low debt-to-equity ratio is financed by a relatively low level of debt and a high level of equity. Most businesses aspire to have a low ratio, which is usually considered to be below 2. However, this number can vary by industry.
- A high debt-to-equity ratio is financed more by debt from lenders than by shareholder equity, and this can put the organization at risk if the overall liabilities are excessive. A high ratio is usually 2 or above, depending on the industry.
The debt ratio is important because it indicates how much of shareholder equity can be used to pay off debt if the business ever declines. This can give an indication of your capital structure and the financial health of the company. When the ratio is calculated it can also help others decide if they want to invest in your business.
How to find debt-to-equity ratio
The debt-to-equity ratio formula is simple:
Total liabilities ÷ Shareholder equity = Debt-to-equity ratio
This means that if your total liabilities are $600,000, and your equity is $200,000, then your debt-to-equity ratio would be 3. If you are able to pay off some of your debt or liabilities, then you would be able to achieve a lower ratio.
A company with a ratio of 2 is borrowing twice as much as they have in equity, and a company with a ratio of 1 is borrowing exactly as much as they have in equity.
What is a good debt-to-equity ratio?
Usually you want the debt-to-equity ratio of your business to be lower than 2. Some investors feel the ideal number should be a ratio of 1 or lower, as this indicates that all liabilities could be paid off with equity if the business falters. Debt is risky, so investors often look for companies with a balance sheet that indicates a low debt-to-equity ratio—and thus a lower risk of defaulting on their loans.
Relatively high levels of debt aren’t necessarily a bad thing—it’s important to look at the complete picture to understand how businesses are using their debt to create profits. Companies with high levels of fixed assets, such as manufacturing, will likely have a higher ratio than 2.
Understanding total liabilities
What are total liabilities? This term includes:
- Short-term debt
- Long-term debt
- Accounts payable
- Deferred tax liabilities
- Other fixed payment obligations
Debt is just one type of liability, so your total debt might not describe your total liabilities.
What is considered debt?
Because debt is part of your liabilities, it’s important to understand what this category describes.
- Drawn line-of-credit
- Notes payable
- Bonds payable
- Long-term debt
- Capital lease obligations
Debt does NOT include:
- Accounts payable
- Deferred revenues
- Dividends payable
How to reach a lower a debt-to-equity ratio
If you have a high ratio of debt to equity and you are worried about how your business will fare during a downturn (or if you’re concerned about how it appears to investors), you may want to try lowering your overall liabilities.
The most direct way to do this is by paying down your loans. This can be a slow process, but careful budgeting can go a long way toward reaching this goal. A budget that aligns with your goals will help you find money in places you might not expect.
It may also be possible to restructure your debt when the market allows. You’ll also want to avoid taking on new debt, if possible.
You can also increase the profitability of your business to pay down debt—but running a very profitable business is likely one of your primary goals already.
Once your overall debt is lower (or your equity is higher), you will have a lower ratio.
Debt-to-equity ratio example
Let’s see what this ratio can look like in the real world. As of September 2021, Microsoft had a long-term debt of $183.44 billion, and $151.98 billion in total shareholder equity. While this debt amount does not include all of the company’s liabilities, because Microsoft is such a large organization, it likely covers the majority of them.
$183.44 billion divided by $151.98 billion is 1.21, which is a pretty solid debt-to-equity ratio. While this is not the only number that investors can use to determine economic health, it is a useful indicator of how Microsoft prioritizes sources of capital.
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