Simply put, the debt to equity ratio (D/E) compares a company’s total debt to total equity. It is calculated as follows: D/E ratio = Total Liabilities/Shareholders Equity. It is a measurement of whether the company can cover its debt and an indication of how leveraged the company is. The higher the ratio, the more difficult it may be for the business to cover all its liabilities.
What is a good debt to equity ratio?
This ratio can vary by industry and some industries tend to use more debt financing than others. A small business owner with a team working remotely and little to no loans or leases will look a lot different than a small manufacturing company with equipment leases, lines of credit, and other assorted liabilities.
The calculation for the debt to equity ratio details for the business owner how leveraged the business is and how it may affect the company’s bankability. Banks and other financial institutions may view a higher debt to equity ratio as risky because it shows that the owners/principles haven’t funded the business as much as creditors have. In other words, have you leveraged the business to grow?
Why is it important to understand, monitor, and work on your D/E ratio?
This is about the health of your business, the amount of debt you are using to finance your assets, and your ability to pay your debtors. If the ratio too low, you could be accessing equity to finance your business. If it is too high, it could be an indication of financial trouble. Knowing this and understanding it will help with decisions you need to make about growth, new hiring, purchasing and overall expenses.
Ok, so where do I go from here?
Resources and tools are available to assist you with calculating and understanding your D/E ratio. Your accountant is a perfect place to start and can assist you with the calculations as well as critical decisions to manage the ratio.
In addition, web apps like Expex can help you monitor your company’s financial health and offers desktop, text and email alerts insuring your ratio does not divert from the healthy settings you and your accountant have set up.
No worries, it sounds a bit scary and overwhelming but the debt to equity ratio can be a simple window in the health of your business. Need more help, contact us, we’ll show you how it’s done.