By Chron Contributor Updated August 13, 2020
A debt-to-equity ratio measures the amount of debt a company uses to fund its business for every dollar of equity it has. The debt-to-equity ratio formula is: Total liabilities divided by total stockholders’ equity, which are found on the balance sheet. The higher the ratio is, the more debt a business uses compared to equity. A ratio that is too high can potentially cause problems in your small business. According to Corporate Finance Institute, this ratio may also be called a risk ratio, gearing or a leverage ratio.
Defining a High Debt-to-Equity Ratio
Acceptable debt-to-equity ratios differ among industries. In general, a ratio that is greater than the industry average is too high. For example, if your small business has $400,000 in total liabilities and $250,000 in total stockholders’ equity, your debt-to-equity ratio is 1.6. This means you use $1.60 in debt for every $1 of equity, or your debt level is 160 percent of your equity. If the industry average is 0.9, you are one of the companies with a high debt-to-equity ratio.
Reduced Ownership Value
Liabilities and equity represent the respective claims that creditors and owners have on a company’s assets. A debt-to-equity ratio increase means a reduction in the value of owners’ stake in a business as a proportion of its assets. If your small business has a high debt-to-equity ratio and you sell or liquidate the company, you would have to distribute a larger portion of the proceeds to creditors than if you had a low debt-to-equity ratio.
Increased Risk
The risk of defaulting on, or being unable to repay, your debt increases as your debt-to-equity ratio rises. A reasonable amount of debt can help you grow your small business, but too much can overburden you with high interest payments. You have to generate more business just to break even. If you fail to make these interest payments, creditors might take your company’s assets or force you into bankruptcy.
Trouble Obtaining Additional Financing
Banks typically require a low debt-to-equity ratio when they extend new credit. Because a high debt-to-equity ratio reduces a bank’s chances of being repaid, it might refuse to provide additional funding or might give you money only with unfavorable terms. Say your debt-to-equity ratio is 2 and the bank’s cutoff is 1.5; it would likely deny you a loan.
Violating Debt Covenants
Loan agreements often include covenants, which are stipulations that require a business to do or not do certain things, such as maintain adequate financial ratio levels. If your debt-to-equity ratio exceeds that allowed by a covenant with an existing lender, the lender might call your entire loan due. For example, if an existing lender requires you to keep your debt-to-equity ratio below 1.8 and it jumps to 2.1, you would violate the covenant.
Examples of Debt-to-Equity Ratios by Industry
Below are some common industries along with their associated debt-to-equity ratios, according to CSI Market, so you can compare yourself and see where your business stands.
- Energy: 0.61
- Technology: 0.62
- Retail: 0.93
- Financial: 1.02
- Healthcare: 1.06
- Services: 1.22
If, for example, you run a nail salon service with a debt-to-equity ratio of 1.34, you may want to consider trying to improve this ratio to get your business at or under the industry standard of 1.22. Doing so would help make your business finances more robust, as well as give a better chance at securing financing if needed.
FAQs
1. If the company has a high debt-to-equity ratio, any losses incurred will be compounded, and the company will find it difficult to pay back its debt. 2. If the debt-to-equity ratio is too high, there will be a sudden increase in the borrowing cost and the cost of equity.
What is the issue with a high debt-to-equity ratio? ›
The debt-to-equity (D/E) ratio reflects a company's debt status. A high D/E ratio is considered risky for lenders and investors because it suggests that the company is financing a significant amount of its potential growth through borrowing.
Which one of the following is a disadvantage of a high debt ratio? ›
Which ONE of the following is a DISADVANTAGE of a HIGH DEBT RATIO? If return on assets is lower than the interest rate associated with the high debt, profits can be reduced dramatically.
Why is a high debt ratio bad? ›
For lenders and investors, a high ratio means a riskier investment because the business might not be able to make enough money to repay its debts. If a debt ratio is lower - closer to zero - this often means the business hasn't relied on borrowing to finance operations.
Is it good to have a high or low debt-to-equity ratio? ›
In general, a lower D/E ratio is preferred as it indicates less debt on a company's balance sheet.
What does a high debt-to-equity ratio indicate quizlet? ›
A high debt ratio indicates that a corporation has a high level of financial leverage. What is the Debt-to-Equity ratio? Total Liabilities/Total Owner's Equity. The D/E ratio indicates how much debt a company is using to finance its assets relative to the amount of value represented in shareholders' equity.
What are the disadvantages of high debt? ›
Increased Risk
A reasonable amount of debt can help you grow your small business, but too much can overburden you with high interest payments. You have to generate more business just to break even. If you fail to make these interest payments, creditors might take your company's assets or force you into bankruptcy.
What is the problem with high debt? ›
At high debt levels, governments have less capacity to provide support for ailing banks, and if they do, sovereign borrowing costs may rise further. At the same time, the more banks hold of their countries' sovereign debt, the more exposed their balance sheet is to the sovereign's fiscal fragility.
Is a higher debt ratio worse? ›
From a pure risk perspective, debt ratios of 0.4 or lower are considered better, while a debt ratio of 0.6 or higher makes it more difficult to borrow money.
Is a high debt to ratio good? ›
A general rule of thumb is to keep your overall debt-to-income ratio at or below 43%. This is seen as a wise target because it's the maximum debt-to-income ratio at which you're eligible for a Qualified Mortgage —a type of home loan designed to be stable and borrower-friendly.
However, the biggest risk in this scenario is the inability to pay off debts. If an individual is unable to make their debt payments, they may face serious consequences such as damage to their credit score, collection efforts, or even legal action.
Is it normal for banks to have high debt-to-equity ratio? ›
A higher D/E ratio means that more of a company's financing is from debt versus issuing shares of equity. Banks tend to have higher D/E ratios because they borrow capital in order to lend to customers. They also have substantial fixed assets, i.e., local branches, for example.
What is the disadvantage of debt ratio? ›
1. If the company has a high debt-to-equity ratio, any losses incurred will be compounded, and the company will find it difficult to pay back its debt. 2. If the debt-to-equity ratio is too high, there will be a sudden increase in the borrowing cost and the cost of equity.
Which of the following is a disadvantage of debt financing? ›
The main disadvantage of debt financing is that it can put business owners at risk of personal liability. If a business is unable to repay its debts, creditors may attempt to collect from the business owners personally. This can put business owners' personal assets at risk, such as their homes or cars.
What is a bad debt ratio? ›
The bad debt to sales ratio represents the fraction of uncollectible accounts receivables in a year compared to total sales. For example, if a company's revenue is $100,000 and it's unable to collect $3,000, the bad debt to sales ratio is (3,000/100,000=0.03).
