Debt-to-equity Ratio: How the Math Works for Your Business (2024)

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.

Debt-to-equity Ratio: How the Math Works for Your Business (1)

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.

Debt-to-equity Ratio: How the Math Works for Your Business (2024)


Debt-to-equity Ratio: How the Math Works for Your Business? ›

The formula for calculating the debt-to-equity ratio is to take a company's total liabilities and divide them by its total shareholders' equity. A good debt-to-equity ratio is generally below 2.0 for most companies and industries.

How do you calculate a company's debt-to-equity ratio? ›

The debt-to-equity (D/E) ratio is used to evaluate a company's financial leverage and is calculated by dividing a company's total liabilities by its shareholder equity.

What is the debt-to-equity ratio for dummies? ›

The D/E ratio is a metric that can tell investors what proportion of a company's operations are funded with borrowed capital. The debt-to-equity ratio is calculated by dividing a company's total liabilities by its shareholders' equity.

How do you calculate debt ratio for a business? ›

To calculate the debt-to-assets ratio, divide your total debt by your total assets. The larger your company's debt ratio, the greater its financial leverage. Debt-to-equity ratio : This is the more common debt ratio formula. To calculate it, divide your company's total debt by its total shareholder equity.

How does the debt equity ratio measure the profitability of the business? ›

The debt-to-equity ratio measures solvency, which is the ability of a company to pay its debt and continue operating the business in the future years. The current ratio measures a companies liquidity, which is the ability of companies to convert current assets into cash. Profitability is measured through net income.

What is the ideal debt to equity ratio for a company? ›

The optimal D/E ratio varies by industry, but it should not be above a level of 2.0. A D/E ratio of 2 indicates the company derives two-thirds of its capital financing from debt and one-third from shareholder equity.

What is the formula for debt-to-equity capital ratio? ›

The debt-to-equity ratio (D/E ratio) depicts how much debt a company has compared to its assets. It is calculated by dividing a company's total debt by total shareholder equity.

How do you interpret the debt-to-equity ratio? ›

Interpretation. A high debt-to-equity ratio indicates that a company is borrowing more capital from the market to fund its operations, while a low debt-to-equity ratio means that the company is utilizing its assets and borrowing less money from the market. Capital industries generally have a higher debt-to-equity ratio ...

How do you explain debt ratio? ›

The debt ratio is defined as the ratio of total debt to total assets, expressed as a decimal or percentage. It can be interpreted as the proportion of a company's assets that are financed by debt.

What does a debt-to-equity ratio of 1.75 mean? ›

D e b t t o E q u i t y r a t i o = T o t a l l i a b i l i t i e s T o t a l E q u i t y. A value of $1.75, therefore, indicates that for every dollar of equity, a firm uses $1.75 in debt to finance its assets. This ratio indicates that the business has more credit financing than the owner's financing.

What is a good debt ratio for a small business? ›

Lenders often rely on DTI ratios to evaluate their creditworthiness and determine whether to approve a loan or extend credit. Generally, a DTI ratio of 36% or less is considered ideal, indicating a healthy balance between income and debt.

How do I figure out my debt to ratio? ›

How do I calculate my debt-to-income ratio? To calculate your DTI, you add up all your monthly debt payments and divide them by your gross monthly income. Your gross monthly income is generally the amount of money you have earned before your taxes and other deductions are taken out.

What is the formula for the equity ratio? ›

Equity Ratio = Shareholder's Equity / Total Asset

We can see that the equity ratio of the company is 0.65. This ratio is considered a healthy ratio as the company has much more investor funding than debt funding.

How to calculate debt-to-equity ratio calculator? ›

You can calculate your business' debt to equity ratio (D/E) by dividing the total liabilities by shareholders' equities. In other words, it is represented by the total debt divided by shareholder shares. This essential information is present in the balance sheet of every company.

How do you analyze a company's debt-to-equity ratio? ›

Key takeaways:
  1. The formula for calculating the debt-to-equity ratio is to take a company's total liabilities and divide them by its total shareholders' equity.
  2. A good debt-to-equity ratio is generally below 2.0 for most companies and industries.
Jan 31, 2023

What is a bad debt-to-equity ratio? ›

What is a bad debt-to-equity ratio? When the ratio is more around 5, 6 or 7, that's a much higher level of debt, and the bank will pay attention to that. “It doesn't mean the company has a problem, but you have to look at why their debt load is so high,” says Lemieux.

What is the formula for debt to value ratio? ›

How to Calculate the Loan-to-Value Ratio. An LTV ratio is calculated by dividing the amount borrowed by the appraised value of the property, expressed as a percentage. For example, if you buy a home appraised at $100,000 for its appraised value, and make a $10,000 down payment, you will borrow $90,000.

How do you calculate debt to asset ratio from equity? ›

You'll be looking for total assets and total liabilities, both current and non-current. To figure the equity-to-asset ratio, simply divide the value of your equity by the value of your assets. Equity is calculated by subtracting the total liability from the total value of your assets.

How do you calculate debt to worth ratio? ›

The debt to net worth ratio is obtained by dividing the total liabilities by the net worth. The total liabilities is the sum of all the monies owed to creditors. The net worth is the difference between the sum of all assets and the liabilities.

What is the debt value ratio to the debt equity ratio? ›

The proportion of a firm's capital structure supplied by debt and by equity is reported as either the debt to equity ratio (D/E) or as the debt to value ratio (D/V), the latter of which is equal to the debt divided by the sum of the debt and the equity. Financial risk is associated with the firm's capital structure.

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