Small Business Accounting Guide

17. How to Calculate Your Debt-to-Equity Ratio

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Business Finance

How to Calculate Your Debt-to-Equity Ratio

Apr 20, 2023 • 6 min read
Business owner doing some accounting work
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      Business owners often get swept up in their day-to-day responsibilities, but meeting long-term goals also requires financial planning. One of the most important aspects of your business for you to analyze is its capital structure, which refers to the mix of debt and equity used to finance its operations.

      The debt-to-equity ratio can provide insight into the health of your business’ financing arrangements. Here’s what you need to know to calculate it and incorporate it into your business decisions.

      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.

      Example Business, Inc.
      Balance Sheet
      December 31, 2020
      Current Assets
        Cash$ 30,000.00
        Accounts Receivable8,500.00
        Prepaid rent7,000.00
            Total Current Assets80,500.00
      Property, Plant, and Equipment
        Accumulated Depreciation(85,000.00)
            Total Property, Plant, and Equipment195,000.00
      Intangible Assets
            Total Intangible Assets75,000.00
      Total Assets$ 350,500.00
      Current Liabilities
        Accounts Payable$ 10,000.00
        Current Portion of Long-Term Debt20,000.00
        Unearned Revenues12,000.00
            Total Current Liabilities42,000.00
      Long-Term Liabilities
        Notes Payable48,000.00
        Business Loan90,000.00
            Total Long-Term Liabilities138,000.00
      Total Liabilities180,000.00
      Owner’s Equity
        Retained Earnings145,500.00
            Total Owner’s Equity170,500.00
      Total Liabilities and Owner’s Equity$ 350,500.00

      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.

      About the author
      Nick Gallo, CPA

      Nick Gallo is a Certified Public Accountant and content marketer for the financial industry. He has been an auditor of international companies and a tax strategist for real estate investors. He now writes articles on personal and corporate finance, accounting and tax matters, and entrepreneurship.

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