When it comes to managing your small business finances, understanding the debt to equity ratio (D/E ratio) can be a real gamechanger. The D/E ratio = total debt / total equity, and in this article we’ll cover what exactly debt and equity are, how to calculate the ratio, and how knowing it can help you.
Also, this guide is related to our articles on understanding owner’s equity, understanding return on assets, and how to calculate break-even point in sales.
This list includes:
- Debt to equity ratio formula
- Optimal debt to equity ratio
- Impact of a high debt to equity ratio
- Benefits of a low debt to equity ratio
- Strategies to improve your debt to equity ratio
Let’s get right into it!
The basics: what are debt and equity?
Let’s start off by breaking down some basic concepts you need to know.
First up, what is debt? Debt is simply money that you owe. In your business, this could include things like loans, credit cards debt or mortgages you’ve taken out to help finance your operations. Many small businesses rely on debt to function, from buying equipment, leasing a storefront, or just for covering everyday expenses.
Next, let’s talk about equity. Sound complicated? It’s simpler than you might think. Equity is what you truly own in your business. Essentially, it’s the value of an asset—like your business—once you subtract what you owe (your debt).
If you sold your business today and paid off all your debts, the amount of money you’d have left over is your equity. It reflects the genuine value of your business, without the burden of debt.
Calculating the debt to equity ratio
The formula is straightforward: debt divided by equity equals the debt to equity ratio.
If your business debt is $50,000 and your equity is $100,000, that would be 50,000 / 100,000 = 0.5. So your debt to equity ratio is 0.5.
What does this number mean? Essentially, the debt to equity ratio shows how much debt you’re using to finance your business compared to your own funds (or equity). A higher ratio means that you’re relying more heavily on borrowed funds, while a lower ratio means your business is more heavily financed by your own funds, the value you’ve actually built up in your business.
These numbers are important because they tell you, the business owner, where your money is coming from—your pockets or a lender’s. If you have too much debt, your business could be at risk if interest rates rise or business takes a downturn.
How the debt to equity ratio affects your business
For starters, a high ratio increases the risk of business failure. If a business relies too much on debt to finance its operations and doesn’t generate enough returns, it may not be able to meet its debt obligations, potentially leading to bankruptcy.
The ratio also impacts your business’ credit rating, and creditors look at it when deciding whether to lend to you and in then determining the interest rate on that loan. If a business’ ratio is high, it’s higher risk, and creditors may charge higher interest rates to compensate.
Having a lower ratio can, on the other hand, provide greater flexibility to take on additional debt for expansion or improvements when needed. It also makes your business more appealing to investors—less financial risk.
Optimal debt to equity ratio
Your industry influences your debt to equity ratio and each has a benchmark to guide businesses.
For instance, construction or manufacturing businesses may have a higher optimal ratio due to capital intensive operations. Service-oriented businesses, like consultancies or retail shops, might have a lower optimal ratio since they rely less on expensive equipment or facilities.
Not every business in your industry will have the same optimal ratio. Size matters. A larger business might have a higher ratio because they can access loans more easily than a small business.
The business model is also important. Businesses that specialize in high-end products might have utilization rates and income that allow for a higher ratio, while a business focused on budget products will need a lower ratio to keep costs down.
Benefits of maintaining a healthy ratio
A good debt to equity ratio has tangible benefits.
- It shows financial stability. Investors are more likely to invest in your business, and lenders to approve loans. It also means a boost for your business’s credit score, which could lead to better interest rates.
- It balances risk and return. Too much debt increases the risk of bankruptcy, especially if your income dips unexpectedly. But without any debt, you also limit your business’s potential expansion and profitability. An optimal debt to equity ratio navigates this balance well, allowing growth without too much risk.
- Finally, it can affect your profits. A high ratio might mean higher interest on your debt, eating into your profits. A lower ratio could mean less interest to pay, offering more potential to reinvest profits back into the business.
Impact of a high debt to equity ratio
When you have a high debt to equity ratio, you’re relying heavily on borrowed money to manage your business operations. Sure, having access to credit can be great in some situations, like when you need to make an investment or increase working capital. But if your debt level is excessively high, you run the risk of defaulting on your repayments, and that’s definitely not good news.
Risk from lenders’ perspective
From a lender’s point of view, a high debt to equity ratio means you’re a risky proposition. Lenders and creditors are generally less willing to extend additional credit to businesses with high debt to equity ratios because they may worry about your ability to repay. If you default on your debt, it can lead to a chain of unwanted consequences, including legal troubles, a tarnished reputation, and strained relations with creditors.
Impact on profitability
When a significant portion of your income goes towards managing your debts, it directly impacts your profitability. High debt repayments inevitably eat into your profits, leaving very little to invest back into the business or for emergency funds. Poor profits can also worry investors and stakeholders, who may withdraw their support from a business that’s not making money.
Stifled growth
High debts can hinder growth. When all your resources are funneled into paying off debts, there may be inadequate funds left over to explore new investment opportunities or expand your business. As a result, the growth of your business could be stifled, and you could lag behind your competition.
Increased financial pressure
A high debt to equity ratio often leads to increased financial pressure on your business. This could mean constant worry about meeting debt obligations, operating under the fear of bankruptcy, and dealing with pressure from lenders.
Benefits of a low debt to equity ratio
Having a low debt to equity ratio, where your business relies more on its own assets and less on borrowed money, has definite benefits.
Financial independence
Low debt to equity ratio shows financial independence. You don’t owe much money to creditors or third parties, so you’re the one in control, and your business decisions aren’t dictated by repayment schedules or interest rates. It’s liberating not having to worry about repaying large sums of money you don’t really own.
Less interest payments
When you have less debt, you’ll naturally pay less interest. This frees up money for reinvestment into the business. Buying new equipment, hiring more staff, or expanding your marketing campaign, whatever you need: you can use that saved money to grow your business, rather than pay off lenders.
Healthy cash flow
When your business has a lower debt load, it’s easier to maintain a healthy cash flow, since more of your profits remain in your business instead of flying away as debt payments. You can then respond to unexpected expenses or take advantage of growth opportunities as they arise.
Attract investors and lenders
A low debt to equity ratio can make your business more attractive to investors and lenders. It signals that your business isn’t overly dependent on external financing, which makes you a safer bet for them. If you do need to borrow money in the future, having a low debt to equity ratio might get you better terms or lower interest rates.
Positive business image
Finally, a low debt to equity ratio can contribute to a sound business image, and customers, suppliers, and potential partners are more likely to view your business as stable and well-managed.
Strategies to manage and improve your debt to equity ratio
Paying off debt: This is the big one. Pay down any outstanding loans or credit you have. The faster you do it, the better. Starting a business can drill a hole in your personal savings, and it’s often challenging to prioritize debt repayment. But making those payments a priority whenever possible can save your business money in the long term.
Reinvest your business profits: Instead of pocketing all your profits, consider putting a portion back into the business. This increases your equity, which in turn reduces your debt to equity ratio.
Debt restructuring: Have you considered negotiating with your creditors to alter the terms of your existing debt? This could be extending the repayment period, reducing the interest rate, or even forgiving a part of the principal debt. Depending on the specific circumstances of your business, one or more of these options may be possible.
Starting by engaging in open, honest communication with your lenders. By keeping them in the loop about your financial position, you can work together towards finding a mutually beneficial solution.
Consult a debt restructuring advisor or attorney if you need expert guidance. Restructuring should not become your go-to solution for managing high debt, though. It’s a tool that can provide temporary relief but over-reliance on it could signal financial instability to your stakeholders.
Increase equity: Another strategy to improve your debt to equity ratio is to increase your equity. Here are some practical ways you might consider:
- Inject personal funds: You can invest your own personal funds into the business. This will immediately increase the equity share of your financing mix, improving your debt to equity ratio.
- Retain profits: Instead of distributing all profits as dividends to yourself or other shareholders, consider retaining part of them in the business. These retained earnings will increase the overall equity capital.
- Raise fresh equity: Issuing new shares to investors is another option. Although it might dilute your ownership, it can bring additional equity into the business without creating any repayment obligations.
Whichever route you choose, make sure it aligns with your overall business objectives and financial strategy.
Common mistakes and misconceptions
A common misstep is misunderstanding or incorrectly interpreting financial ratios. Financial ratios offer important insights into your business’s financial health. However, they can be deceptive if not properly understood or applied.
For example, seeing a high debt-to-equity ratio could lead you to conclude your business has too much debt. But this isn’t always the case. A high debt-to-equity ratio might mean your business is using borrowed money to fuel growth. If the return on these borrowed funds exceeds the interest paid on the debt, your business could be in a strong financial position despite the high debt level.
Another frequent mistake is over-emphasizing debt reduction without any strategic planning. Yes, reducing debt is beneficial. It can lower your financial risk and increase your business’s stability. But abruptly slashing debt without a strategic plan could harm your business’s growth and profitability.
Take, for instance, rapidly cutting down your debt by liquidating assets. This quick fix might seem appealing, but it could limit your capacity to generate income. The assets you sold might have been crucial for your products, services, or operational processes.
Or say you decided to repay debts quickly by using your cash reserves. While this will decrease your debt, it will also deplete your cash flow and could leave you in a tight spot, unable to cover unexpected expenses or take on new business opportunities.
When reducing debt, plan strategically. Think about the long-term implications. How will it affect your business operations? Will it limit your ability to generate income?
Conclusion
Taking on debt is not always a negative. If managed well, it can provide the funds necessary to grow and expand your business. Just make sure you don’t lose sight of your equity.
Keep an eye on your industry’s average debt to equity ratio, so you know how you’re performing compared to your peers. If your ratio is well above the industry average, it might be time to reconsider your financial strategy.
Lastly, keep your bank, investors, and creditors informed about your debt to equity ratio. It builds trust and can open doors to additional funding opportunities.
Next, check out our articles on understanding retained earnings, cash vs. accrual accounting, and understanding gross vs. net profit.
FAQ: Understanding the debt to equity ratio
Here’s some answers to commonly asked questions about understanding the debt to equity ratio.
What is the debt to equity ratio and why is it important in financial management?
The debt to equity ratio (D/E ratio) is a financial ratio indicating the relative proportion of shareholders’ equity and debt used to finance a company’s assets. It’s calculated by dividing total debt by total equity. This ratio provides insights into a company’s financial leverage and risk. High ratios reflect substantial reliance on debt, potentially escalating financial risks. Conversely, lower ratios show that the company primarily finances its assets with equity, indicating lower risk.
How does the D/E ratio affect the company’s financial health and its appeal to investors and lenders?
A high D/E ratio indicates that a company relies heavily on borrowed money to finance its operations. This could potentially lead to financial distress if the company can’t generate sufficient returns to meet its debt obligations. Such companies might be deemed risky by lenders and may face higher interest rates on loans. On the other hand, a lower D/E ratio suggests the company is mostly financed by equity, indicating lower financial risks and potentially making the company more appealing to lenders and investors.
How can a small business maintain an optimal D/E ratio?
Maintaining an optimal D/E ratio often involves a combination of debt management and increasing equity. Debt can be managed by regular repayments, renegotiating debt terms, and avoiding unnecessary borrowing. Increasing equity might involve reinvesting profits back into the business or raising additional funds through new investors.
