Sometimes, debt is a necessary evil when running a business. Taking on debt may be your best option when you don’t have enough equity to operate. But, how much debt is too much debt? And, when does debt become “bad”? The accounting debt-to-equity ratio can help you determine how much is too much and draws the line between good and bad debt ratios.
What the debt-to-equity ratio tells you
Again, debt can be necessary to run your business. You may not have sufficient equity to make large purchases your business requires to operate. Some examples of debt include:
- Business loans
- Mortgages
- Deferred taxes
- Accrued expenses
- Utilities
- Outstanding invoices
But, what exactly are debt and equity?
- Debt: Debt is all the liabilities that your business owes to another entity, such as a business, organization, employee, government agency, or vendor. You typically incur debt as part of your normal business transactions
- Equity: Equity is the ownership or value of a company. Equity can be the amount of funds (aka capital) you invest in your business
The debt-to-equity ratio meaning is the relationship between your debt and equity to calculate the financial risks of your business.
The debt-to-equity ratio calculates if your debt is too much for your company. Investors, stakeholders, lenders, and creditors may look at your debt-to-equity ratio to determine if your business is a high or low risk. The higher the risk, the less likely you are to receive loans or have an investor come on board (which we’ll get into more later).
As the business owner, use the debt-to-equity ratio interpretation to decide whether you can or cannot take on more debt. If you have more debt than equity, you may not qualify for loans. If you have more equity than debt, your business may be more appealing to investors or lenders.
What is the equity formula?
Before you can use the debt-to-equity ratio formula, you must calculate your business’s equity. Use your balance sheet to find your total amount of assets and liabilities. Then, use the following formula to determine equity:
Equity = Assets – Liabilities
Let’s say you saved $10,000 to start your company. Your other assets include $5,000 in inventory and equipment. So, you have $15,000 in assets ($10,000 + $5,000). You also have $5,000 in liabilities. Plug the totals into the formula to get your total equity.
$10,000 = $15,000 – $5,000
You have $10,000 worth of equity.
As time passes, your liabilities increase to $18,000, and your assets are $10,000.
– $8,000 = $10,000 – $18,000
If your liabilities are more than your total assets, you have negative equity. In this example, you have a negative equity amount of $8,000.
What is the debt formula?
You also need to know your total debt to determine the debt-to-equity ratio. Use the following formula to determine your business’s total debt:
Total Debt = Long Term Debt + Short Term Debt + Fixed Payments
Again, use the balance sheet to look at your liabilities. Add all of your liabilities together to get your total business debt.
For example, you have a $2,000 bank loan, $2,500 in accounts payables to vendors, and fixed payments of $500. Add together your liabilities to get your total debt.
$5,000 = $2,000 + $2,500 + $500
Your total debt is $5,000.
What is the debt-to-equity ratio formula?
Now that you know how to calculate your equity and debt, it’s time to learn how to use the equity ratio formula. Here is the formula:
Debt-to-equity Ratio = Total Debt / Total Equity
Let’s use the above examples to calculate the debt-to-equity ratio. You have a total debt of $5,000 and $10,000 in total equity.
0.5 = $5,000 / $10,000
Your debt-to-equity ratio is 0.5.
Now, look what happens if you increase your total debt by taking out a $10,000 business loan. Your new total debt is $15,000, and your equity is $10,000.
1.5 = $15,000 / $10,000
Your debt-to-equity ratio increases to 1.5.
Debt-to-equity ratio interpretation
Your ratio tells you how much debt you have per $1.00 of equity. A ratio of 0.5 means that you have $0.50 of debt for every $1.00 in equity. A ratio above 1.0 indicates more debt than equity. So, a ratio of 1.5 means you have $1.50 of debt for every $1.00 in equity.
Good vs. bad debt ratio
Again, the debt-to-capital ratio can help you determine if you have too much business debt. But, how do you decide how much is too much? Well, that depends on your business and the services or goods you offer.
What is a good debt-to-equity ratio? Generally, lenders see ratios below 1.0 as good and ratios above 2.0 as bad. However, the ratio does not take into account your business’s industry, so you do have some wiggle room between good and bad. A good debt-to-equity ratio in one industry (e.g., construction) may be a bad ratio in another (e.g., retailers) and vice versa.
Negative debt-to-equity ratio
Sometimes, a business has a ratio that is negative rather than positive. A negative debt-to-equity ratio means that the business has negative shareholders’ equity. If your liabilities are more than your assets, your equity is negative.
Typically, lenders, stakeholders, and investors consider a negative debt-to-equity ratio to be risky. When your ratio is negative, it might indicate your business is at risk of bankruptcy.
When to use the debt-to-equity ratio
So, now that you know how to calculate, interpret, and use the total debt-to-equity ratio, you may be wondering when to use it. Take a look at some ways to use the ratio.
Financial analysis
When it’s time for potential lenders or stakeholders to make a decision about your company, they look at your debt-to-equity ratio. Specifically, investors look at your ability to pay off your debt and how much of your company depends on debt.
Stakeholders look at all the financial data as well as your industry. If you are in an industry that performs work and invoices after you complete a project, that information is important. Why? You may be less of a risk because your customers owe you and you’re expecting a payment.
But if you are in an industry that accepts payment upfront, your ratio may indicate a higher risk.
Risk analysis
Investors and stakeholders are not the only ones who look at the risk of a business. Lenders usually use the debt-to-equity ratio to calculate if your business is capable of paying back loans. The credit trustworthiness of your business lets lenders know if you can afford to repay loans.
Lenders also check your past records and installment payments to ensure you actively repay your debts.
Determining shareholder earnings
If you have shareholders, you pay them part of your profits. And when it comes time to pay out the shareholder dividends, you base the shareholder earnings on the business’s profits. But if your debt-to-equity is too high, your profits can decrease. For shareholders, this might mean that you reduce their earnings because you must use your profits to pay any interest or payments on debt.
Keeping track of your debt and equity should be a painless process. Patriot’s online accounting software makes it easy to track all of your income and expenses in one place. Try it free today!
This is not intended as legal advice; for more information, please click here.
