How to Calculate Your Debt-to-Equity Ratio

What is the debt-to-equity ratio?

The debt-to-equity is a financial metric that compares a business’ liabilities to its equity. It’s one of the most frequently used gearing ratios (i.e., metrics that help assess the health of a company’s capital structure).

More specifically, calculating the debt-to-equity ratio helps determine how heavily your business relies on debt for financing. That’s a critical consideration for stakeholders because debt is generally cheaper than equity, but you can only take on so much before you start struggling to meet your obligations.

For example, business owners might calculate their debt-to-equity ratio when considering how best to fund their next project. Similarly, lenders might use it to determine whether or not to give a prospective borrower a loan.

Debt-to-equity ratio formula.

The formula for the debt-to-equity ratio is as follows: 

Debt-to-Equity Ratio = Liabilities ÷ Equity

Your company’s liabilities refer to the amounts it owes to other parties. That includes the various forms of business debt used to finance your operations, such as installment loans, revolving lines of credit, and accounts payable.

However, since the primary purpose of the debt-to-equity ratio is to provide insight into the distribution of financing arrangements used to finance your operations, it sometimes excludes short-term debts due in the next year (Ex: accounts payable) when calculating the ratio.

Assuming you’ve already created your financial statements, you can find both amounts on your balance sheet.

Meanwhile, your business’ equity refers to the financing it’s received through contributions from the original owners and any investors, plus any profits left in the company from previous years that you didn’t distribute back to them. It also represents what would be left if you sold all your assets and paid off your liabilities.

How to calculate the debt-to-equity ratio.

Let’s run through a practical example to demonstrate how you’d calculate the debt-to-equity ratio using the information in your company’s financial statements. Say that you own a small business with the following balance sheet.

Assuming you want to include all your business debts in your debt-to-equity ratio, you’d pull the $180,000 total liabilities and the $170,500 in owner’s equity directly from the balance sheet. As a result, your debt-to-equity calculation would be the following:

$180,000 liabilities ÷ $170,500 owner’s equity = 1.06 debt-to-equity ratio

Interpreting your debt-to-equity ratio.

A debt-to-equity ratio of one or less is typically considered low-risk, since it indicates you have more equity than debt. Conversely, a debt-to-equity ratio greater than one indicates that your company has more debt than equity, which can be concerning the closer it gets to two.

That said, the ideal ratio can vary significantly by your industry. Some businesses consistently have higher debt-to-equity ratios without issue, due to the nature of their products and services.

For example, utility companies usually need to expend significant amounts of capital to build the infrastructure necessary to start offering services. However, that’s typically a manageable risk due to the industry’s uniquely stable demand as an essential service.

In addition to the industry, you should consider a business’ other circumstances when assessing the debt-to-equity ratio, such as its profitability and long-term growth prospects. For example, a company with a high debt-to-equity ratio can still be healthy if it has strong cash flows. 

Ultimately, the debt-to-equity ratio is an insightful lens into the strength of a company’s capital structure. However, you must consider it in context with other financial metrics to get an accurate picture of the business’ financial health.

_{Information provided on this blog is for educational purposes only, and is not intended to be business, legal, tax, or accounting advice. The views and opinions expressed in this blog are those of the authors and do not necessarily reflect the official policy or position of Lendio. While Lendio strives to keep its content up-to-date, it is only accurate as of the date posted. Offers or trends may expire, or may no longer be relevant.}