Debt to equity ratios for healthy businesses

When people hear the term "debt," they often associate it with negative concepts such as credit card bills, high interest rates, and even bankruptcy. 

Whilst it’s true that taking on too much debt can make you less flexible and expose you to risk if revenues fall or interest rates rise, in the context of running a business, debt isn't necessarily a bad thing. 

In fact, analysts and investors expect companies to use debt strategically to finance their operations. 
Properly managed debt can be an essential tool for business growth and sustainability.

Exactly what level of debt is suitable for your business depends on your precise requirements at any one time.

There is a healthy level of debt, or 'gearing', that enables a business to grow and capture market share.
It's not an exact science, however, and what's regarded as healthy will also differ from industry to industry.

For example, capital-intensive industries such as manufacturing commonly have higher levels of debt than, say, a tech company that operates online.

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 (a) how financially stable a company is when facing problems with trading or other operational considerations and (b) what ability it has to raise additional capital for growth.

In this article we’ll explain what a debt-to-equity ratio is, how to calculate one, and what it can tell investors about your business.

What is the debt-to-equity ratio?

A company's debt ratio is commonly seen as a measure of its stability.

The ratio measures the level of debt the company takes on to finance its operations, against the level of capital, or equity, that's available.

It's calculated by dividing a business' total liabilities by the total amount of shareholders' equity.

Shareholders' equity represents the company's net worth - that is, the amount shareholders would receive if the company's total assets were liquidated and all of its debts repaid.

It might also be calculated by subtracting the company's total liabilities from its total assets, both of which are itemised on the company's balance sheet.

The resulting figure shows how much the company relies on debt.

A higher ratio suggests that it is more dependent on funding from outside the business, and therefore potentially less stable if it were to encounter problems with trading or other factors relating to how it operates.

How do I calculate a debt-to-equity ratio?

To work out the debt-to-equity ratio of your business, you need to use a simple calculation. 

First, you’ll need your business’s total liabilities, which represent what the business owes to others. 

Then, find your business's shareholder equity, which is essentially the book value calculated as assets minus liabilities. 

Both figures can be found on your company's balance sheet.

The formula for the debt-to-equity ratio is as follows:

Debt-to-equity ratio = total liabilities / shareholders’ equity

To give a practical example, let’s say you run a small cake making business which owes £4000 to debtors such as ingredient suppliers or the landlord for the bakery you rent. 

To work out the debt-to-equity ratio you’ll also need your business’s shareholder equity which for the purpose of this example, we’ll say is £3000.

The debt-to-equity calculation then looks like:

Debt-to-equity ratio = 4000/3000 = 1.33

What debt is included in a debt-to-equity ratio?

A debt-to-equity ratio can include various types of debt, such as:

• short-term liabilities
• long-term liabilities
• accounts payable
• accrued liabilities
• deferred tax liabilities
• bonds payable
• mortgages payable
• leases and other financing arrangements listed on the company's balance sheet
• contingent liabilities like guarantees or litigation.

Understanding which types of debt are included in your debt-to-equity ratio calculation is crucial, as it affects the interpretation of the ratio. 

Short-term liabilities, such as accounts payable, are generally less of a concern since they are expected to be settled within a year. 

However, a high proportion of short-term debt can still raise concerns if a company has difficulty meeting its immediate obligations.

On the other hand, long-term liabilities represent more substantial financial commitments and can significantly impact a company’s financial health. 

When analysing your debt-to-equity ratio, it is important to closely examine the composition of your debt and consider how it might affect your company's ability to fulfil its financial obligations over time.
 

Why is the debt ratio important?

Generally, a good debt ratio for a business is around 1 to 1.5.

However, the debt-to-equity ratio can vary significantly based on the business's growth stage and industry sector. 

For example, newer and expanding companies often utilise debt to drive growth. 

However, the ideal debt ratio will vary depending on the industry, as some industries use more debt financing than others.

Capital-intensive sectors like the financial and manufacturing industries often have higher ratios that can be greater than 2.

Therefore, it is crucial to evaluate debt-to-equity ratios relative to industry peers or the same company at different stages of its development. 

If your business has a debt ratio of over 3 that might be a concern for investors normally but its less of a barrier to investment if the average debt ratio for your industry is 5.

This comparative approach provides a more accurate assessment of financial leverage and stability.

What does a debt ratio say about a business?

A high debt ratio indicates a business using debt to finance its growth.

Companies that invest large amounts of money in assets and operations (capital-intensive companies) often have a higher debt ratio.

For lenders and investors, a high ratio (typically above 2) typically 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.

Investors can be unwilling to invest in a company with a very low ratio, as it suggests the business isn't realising the potential profit or value it could gain by borrowing and increasing the scale of its operations.

This can make it more difficult for a business to make use of equity finance.

Servicing your debt

When deciding what level of debt is suitable for your business, you should consider whether you'll be able to service that debt in the future.

Determining whether your level of debt is healthy means asking questions like the following:

• Do you operate in an industry that naturally requires a high level of debt to function effectively and keep up with competitors?
• How does the result of your debt ratio analysis compare with companies of a similar set-up in your sector?
• Have you provided a personal guarantee for any of the business' borrowing?
• Is your market likely to decline in the near future?
• Could a rise in interest rates affect your ability to service the debt?

Be aware that providing personal guarantees for business borrowing is common, but it can put you at risk of personal liability should the company get into difficulty.

Dealing with debt

If you're having problems dealing with debt, there may be some measures you can take.

Find out more on our Dealing with debt page.

You might also consider debt consolidation and refinancing as possible ways to reduce your monthly repayments.

Even if you don't have any immediate issues, you should make sure your business has sufficient working capital to cope with tougher trading conditions.