Entrepreneurs need a source of capital in order to grow. Without partners investing in a business, it makes it hard for a company to launch new products, expand, and hire good employees. In order to grow, you need to figure out a way to raise capital.
There are two ways most businesses do this: through debt or equity. To get a better understanding of how the debt to equity ratio works, let’s break the terms down, look at what the ratio can tell you, and explain what a good ratio is.
What Is Total Debt?
Total debt is the combination of short-term debt, long-term debt, liability, and other financial obligations such as financing agreements. Below are typical examples of debt that you may see on a company’s balance sheet:
- Accounts payable
- Deferred revenues
- Wages payable
- Short term notes
- Capital leases
- Pension liabilities
- Bonds payable
- Deferred income taxes
What Is Equity?
Equity is what an owner or owners have in value for their business. You can see what your company’s equity is on a balance sheet. First, you’ll want to find the total amount of liabilities your company has. These liabilities consist of loans and other obligations that your company needs to pay for to maintain its operation. Second, you’ll want to find the total amount of assets your company owns. Assets can include inventory, buildings, cash, and vehicles.
To find out what your equity is, take your total assets and subtract your total liabilities. This will equal your business’s value in equity.
Equity = Assets – Total Liabilities
Equity is first seen during the start-up process of a new company. It comes from the owners and shareholders who give the funding to start up the business. When you pay off most of your loans, you are left with more equity and, in return, more profit. Below are examples of a company’s equity:
- Retained earnings
- Preferred stock
- Common stock
- Other comprehensive income
- Contributed surplus funds
- Treasury stock
What Is Debt to Equity Ratio?
Debt to equity ratio is a financial ratio that helps determine a company’s financial leverage.
Debt to Equity Ratio = Total Liabilities ÷ Total Shareholders Equity
The basic calculation is to take the company’s total liabilities divided by the total shareholder equity. This ratio helps lenders determine if a company is a high or low risk loan candidate.
This ratio can be anywhere from zero, all the way to two and beyond. Zero means you have no liabilities and lots of equity. A ratio of one means your liabilities are equal to your equity. Anything beyond a ratio of two could indicate your company is on the brink of financial collapse.
Examples of Debt to Equity Ratio
Let’s bring this to life with a few examples.
An entrepreneur goes into a bank for a business loan to see if he can gain capital to finance a new project. The loan officer looks at his company’s balance sheet and sees he has $120,000 in assets from equipment, vehicles, cash, and shareholder equity. He also has $100,000 in liabilities tied up from loans of previous projects he’s done.
This leaves him with $20,000 in equity. His $100,000 in liabilities divided by $20,000 in equity equals a debt to equity ratio of 5. This means he has $5 of debt for every $1 of equity. The lender will see this as too high and most likely deny his loan application.
Another entrepreneur walks into a bank with the same intentions as the first person. The loan officer looks at her company’s balance sheet and sees that she has $150,000 in assets, shareholder equity, and cash. But she has $50,000 in liability which gives her $100,000 in total equity. Her debt to equity ratio is 0.5. With less short-term debt and more equity funding the company’s growth, her loan application will most likely be approved.
What Does the Debt to Equity Ratio Tell You?
When the ratio is higher than 1, it shows that your total assets are financed by debt. If the ratio is less than 1, it shows that your total assets are financed by equity.
A high debt to equity ratio tells us that a company might not be able to generate enough earnings to satisfy its debt obligations. A low ratio may indicate that a company is not using enough forms of financing to expand and increase profits.
In the short term, some industries can benefit from a high debt to equity ratio, while other industries benefit from a low debt to equity ratio, both of which we’ll dive into next.
Who Benefits From a High Debt to Equity Ratio?
Capital-intensive industries such as car manufacturers, oil production, and transportation sectors are more likely to benefit from a higher debt to equity ratio. Companies within this industry show they can satisfy their debt through means of cash flow, and using their high dollar equity to increase profits. These industries rely on plants, property, and equipment (PPE) to operate. So unless you have a multi-million dollar company with the need for lots of equipment to operate, you most likely won’t benefit from a high ratio.
Who Benefits From a Low Debt to Equity Ratio?
Low-capital industries such as the gig economy sector, virtual assistant services, and data entry services benefit from a lower ratio. Companies in these industries can be built on the majority shareholder’s equity since they don’t need equipment to gain profits.
To get lenders to let you borrow money to grow your business, you need to show them that your equity outweighs your total debt, and you’re not tied up with high liabilities. Therefore, if your company is looking for funding through investors or lenders, it’s better to have a lower debt to equity ratio.
The Most Common Mistake People Make With Their Ratio
There are plenty of common mistakes companies can make with their debt to equity ratio but this is the most common one: Taking out more loans than what your equity is worth. If your total debt is $20,000 divided by your equity of $5,000, that means your debt to equity is 4. A ratio of 4 is too much of a risk for most lenders or other investors.
What Is a Good Debt to Equity Ratio?
Since most of us are not at the helm of a multi-million dollar company, most entrepreneurs will benefit from a lower ratio. From a lender’s point of view, a good debt to equity ratio is considered to be between 0.4 and 1.
Most lenders will have a limit on how much a company can borrow. It will be harder for a business to take loans out if their debt to equity ratio is 1 or higher. It will be especially hard if the business has limited equity to begin with. If your debt to equity ratio is on the high side, here are some suggestions on how to lower your ratio:
- Increase the amount you pay on your monthly debt. Doing this will get your ratio down at a quicker rate and you’ll save on interest.
- Don’t take on more debt. Try to consolidate your spending so you don’t have to apply for more loans.
- Hold back on large purchases so you’re not using much credit. Save up your profit and use the extra money for a larger down payment down the road.
- Downsize your company so you’re not spending as much on operational costs. It may not be a choice you want to make, but it’s better to re-establish yourself now for a chance to grow later.
A low ratio is good, but keep in mind that investors may not want to buy into your business if your debt to equity ratio is zero. This shows investors that you are not using financing to expand operations that could result in a good return for shareholders. It’s better to have some debt to show investors you’re aggressive about growth. Just don’t overdo it.
Grow Your Business Using the Debt to Equity Ratio
If you want your business to grow, you need to make sure your debt to equity ratio is optimal for the type of business you’re running. Some companies can use high leverage to their advantage to gain a return on profits while other companies will need to maintain a lower debt to equity ratio and focus more on capital gain from investor and shareholder assets.
The debt to equity ratio is a simple calculation that can you give you a lot of insight into where your company stands financially. A basic balance sheet will give you the information to see how stable your company is and its strengths and weaknesses.
If you’re an entrepreneur looking to gain more equity and lower your ratio, check out these 15 passive income opportunities to bring in extra cash.