Debt to Equity Ratio, Demystified

Growing a business requires investment capital. When companies are scaling, they need money to launch products, hire employees, assist customers, and expand operations. There are numerous ways to raise capital, and each will have a different impact on your company and the pace at which you grow.

The most common way to raise capital is through either equity or debt. But what do each of these entail? And how do they help your business' financial standing? Well, you're in luck, because we'll take a look in this definitive guide to demystifying the debt to equity ratio.

Leverage is the term used to describe a business's use of debt to finance business activities and asset purchases. When debt is the primary way a company finances its business, it's considered highly leveraged. If it's highly leveraged, the debt to equity ratio tends to be higher.

The debt to equity ratio is a simple formula to show how capital has been raised to run a business. It's considered an important financial metric because it indicates the stability of a company and its ability to raise additional capital to grow.

It is important to note the debt to equity ratio will vary across industries. This is because different types of businesses require different levels of debt and capital to operate and scale.

For example, an apparel company that requires textiles to create the product, labor to assemble the clothing, warehouses to store their products, and brick-and-mortar stores to sell the product to customers is likely going to carry more debt than a tech company that delivers all of its products online and does not have to worry about storing physical products or maintaining a customer-facing physical space. These considerations will greatly impact the debt to equity ratio of these two companies.

Why Is Debt to Equity Ratio Important?

The debt to equity ratio is a simple formula to show how capital has been raised to run a business. It's considered an important financial metric because it indicates the stability of a company and its ability to raise additional capital to grow.

As an entrepreneur or small business owner, the ratio is used when you've applied for a loan or business line of credit.

And for investors, the debt to equity ratio is used to indicate how risky it is to invest in a company. The higher the debt to equity ratio, the riskier the investment.

To further clarify the ratio, let's define debt and equity next.

What is debt?

Debt is an amount owed for funds borrowed from a bank or private lender. The lender agrees to lend funds to the borrower upon a promise by the borrower to pay back the money as well as interest on the debt — the interest is usually paid at regular intervals. A business acquires debt in order to use the funds for operating needs.

A company typically needs hard assets to borrow money from a bank or private lender. A hard asset is a receivable for product or service delivered that is recognized on the company's balance sheet and shows a lender the business is capable of paying back the loan. If a company is new or doesn't have hard assets it's more difficult to borrow.

What is equity?

Equity is stock or security representing an ownership interest in a company. Put simply, it's your ownership in an asset — such as a company, property, or car — after your debt on that asset is paid.

When a business uses equity financing, it sells shares of the company to investors in return for capital. To learn more, check out this guide to equity financing.

Debt to Equity Ratio Formula

Now that we've defined the debt to equity ratio, we'll take a look at how to use it. Below is the formula to calculate the debt to equity ratio:

And here are the two elements that make up the formula:

• Total liabilities: Total liabilities represent all of a company's debt, including short-term and long-term debt, and other liabilities (e.g., bond sinking funds and deferred tax liabilities).
• Shareholders' equity: Shareholders' equity is calculated by subtracting total liabilities from total assets. Total liabilities and total assets are found on a company's balance sheet.

Debt to Equity Ratio Example

Let's say a software company is applying for funding and needs to calculate its debt to equity ratio. Its total liabilities are $300,000 and shareholders' equity is $250,000.

Here's what the debt to equity ratio would look like for the company:

Debt to equity ratio = 300,000 / 250,000

Debt to equity ratio = 1.2

With a debt to equity ratio of 1.2, investing is less risky for the lenders because the business isn't highly leveraged or primarily financed with debt.

A high debt to equity ratio indicates a business uses debt to finance its growth. Companies that invest large amounts of money in assets and operations (capital intensive companies) often have a higher debt to equity ratio. For lenders and investors, a high ratio means a riskier investment because the business might not be able to produce enough money to repay its debts.

If a debt to equity ratio is lower — closer to zero — this often means the business hasn't relied on borrowing to finance operations. Investors are unlikely to invest in a company with a very low ratio because the business isn't realizing the potential profit or value it could gain by borrowing and increasing operations.

A company can experience a negative debt to equity ratio for a number of reasons, including:

• Taking on additional debt to cover losses instead of issuing shareholder equity.
• Expensing intangible assets, such as trademarks, that exceed pre-existing shareholder equity values.
• Making large dividend payments that exceed shareholders' equity.
• Experiencing financial loss in periods following large dividend payments.

When any of these situations occur, they could signal a sign of financial distress to shareholders, investors, and creditors.

As we covered above, shareholders' equity is total assets minus total liabilities. However, this is not the same value as total assets minus total debt because the payment terms of the debt should also be taken into account when assessing the overall financial health of a company.

Short-term debt consists of liabilities that will be paid in under a year. Long-term debt consists of liabilities that will take a year or under to mature. Let's walk through an example.

Company A has $2 million in short-term debt and $1 million in long-term debt. Company B has $1 million in short-term debt and $2 million in long-term debt. Both companies have $3 million in debt and $3.1 million in shareholder equity giving them both a debt to equity ratio of 1.03.

However, because short-term debt is renewed more often, having greater short-term debt compared to long-term debt is considered risky, especially with fluctuating interest rates. With this in mind, Company B would be considered less risky because it has more long-term debt, which is considered more stable.

Here's a reference to help you remember the long-term debt to equity ratio formula.

Examples of long-term debt include mortgages, bonds, and bank debt. Just like the standard debt to equity ratio, investing in a business is riskier if it has a high ratio.

The debt to equity ratio is a valuable tool for entrepreneurs and investors, and it shows how much a business relies on debt to finance its purchases and business activities. If you're interested in entrepreneurship, learn about how to start a business next.

Editor's note: This post was originally published on October 26, 2018 and has been updated for comprehensiveness.