Debt Equity Ratio for Small Businesses

Susan GuilloryUpdated April 19, 2023

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Part of cash management for business is understanding how much debt your business is using in relation to equity (the portion of the company’s value that you own). If you have too much debt in relation to equity, investors might not be interested in your business as a potential investment. Or, if you’re trying to apply for a business loan, lenders might not approve your application if they feel you already have too much debt on your books.Your company’s debt-equity ratio (also called debt-to-equity ratio or D/E ratio) is an important metric for understanding this balance between debt and investment, or equity. It’s also useful for potential investors as a measure of the risk your company presents as an investment.

What Is a Debt-Equity Ratio?

The debt-equity ratio is a measure of how much debt a company has in relation to its equity. It helps determine if a business has enough shareholder/owner’s equity to pay off debts if it were to face a dip in profits.The D/E ratio considers primarily long-term debt (with a repayment schedule longer than one year) for the debt part of the equation, along with the interest due on that debt. Sometimes these debts are referred to as liabilities.For small businesses that don’t have shareholders, the “equity” portion of the equation can be replaced with what you have invested in the business.

How to Calculate Debt Equity Ratio

Calculating your business’ debt-equity ratio is relatively simple. First, you need to determine your businesses total liabilities, including long-term loans and any business mortgage it may have. You can find your total liabilities on your company’s balance sheet. You’ll then need to determine shareholder/owner’s equity, which is calculated by subtracting total liabilities from total assets (total assets are also found on the balance sheet).Next, you can use the following formula to arrive at your D/E ratio. Total liabilities/equity = D/E ratio

Debt-Equity Ratio Calculation Example

Let’s look at an example. Say your business has long-term debt (or liabilities) of $10,000, which includes a commercial real estate mortgage and a small business loan. You’ve invested $100,000 in this business and have no shareholders. So your calculations would look like this:10,000/100,000Debt-equity ratio: 0.1This is a very low debt-equity ratio (anything under 1 is considered low risk, while ratios over 2 are typically thought to be risky).

Why Debt Equity Ratio Matters

So you’ve calculated your long-term debt to equity ratio...now what? It’s an important figure for several reasons.First of all, your debt equity ratio is an indicator of the level of risk your business presents to potential lenders. It essentially tells a lender how much debt your company is currently using to finance its operations. If your business is already heavily leveraged (and, thus, has a high D/E ratio), it may be harder to get a business loan, since any lenders you approach may see you as high risk. If profits decline, you may not be able to repay your debts.Potential investors will also look at your company’s debt-equity ratio. This ratio, along with other key financial ratios, helps them understand how well the business is performing and if they will likely get a good return on their investment. Again, though the standards vary by industry, in general a D/E ratio of more than 2 is seen as risky, and anything under 1 is considered low risk.As a business owner, it’s helpful to compare your company’s debt-equity ratio to the D/E ratio for a comparable period in the past, whether that’s a quarter or a year. Looking at historic data can give you a better understanding of how your company has used debt for growth over time. It may also be helpful to look at industry averages, since some industries, like construction, naturally have higher debt-to-equity ratios than others, like agriculture. Your debt-equity ratio is also an important component of understanding what the cost of capital is. While debt can be handy for covering costs when you don’t have cash stockpiled, it can potentially cost more than it helps you generate in additional revenue. By understanding your reliance on debt, you can make more informed decisions for your business’s financial future.Recommended: Finding Investors for a Business

6 Ways to Help Lower Your Debt Equity Ratio

If your debt equity ratio is higher than you’d like, here are a few ways to improve it.

1. Prioritize Paying Down Debt

While debt may provide your business with access to working capital, it may also be holding you back. The longer you take to pay off debt, generally the more it will cost you in interest and fees. It’s a good idea to analyze the debts you have and develop a plan to pay them off more quickly if it’s at all possible. Even putting an extra $200 toward debt each month could significantly reduce the cost of that loan over time.

2. Consider Consolidating Debt

While you’re examining your debt, look at what it’s costing you. Interest rates fluctuate over time, and you may be paying more in interest than you would if you took out a loan today. If that’s the case, consider loan consolidation. With this financing tool, you can roll all your business debt into one monthly payment at one interest rate. Consider this only for loans that you’re paying a higher interest for than the one you could qualify for with a new loan. For example, if you’re paying off a business loan with a 2.99% interest rate and the best you could do with a consolidated rate is 4.00%, it’s probably not worth it.Recommended: Refinance a Business Loan: Complete Guide

3. Have a Plan for Your Debt

If you have good credit, you likely get offers for business loans fairly often. It can be tempting to take out financing just to have access to capital. But it’s important to know what you’ll use that money for to be sure it would be worth the cost.It’s often a good idea to create a budget for how you’ll spend the money, and forecast how much additional revenue that investment could bring. Some examples of good ways to spend loan proceeds include:

Hiring employees who can help you serve more customers
Expanding office space to accommodate growth
Purchasing larger orders of inventory to save per unit

Each of these activities may help you boost revenues and profits, meaning that taking out a loan to pay for them could be worth the cost.Recommended: What Is the Typical Interest Rates on a Business Loan?

4. Work on Revenue-Building Activities

If you can’t cut debt, you may be able to work on boosting revenue. You can do this by raising your prices, adding new high-profit products to your line, or expanding who you sell to.

5. Lower Cost of Goods Sold

To increase profitability, you might look for ways to cut the cost of creating your products. That might mean shopping for a vendor who can offer the materials you use at a lower price, negotiating with your current vendor by placing larger orders for a lower per-unit price, or finding more affordable materials.

6. Have Efficient Systems in Place

A lot of the capital loss in small businesses happens because of human error. Maybe you miscalculated inventory, and now a customer who wants to buy a product has to walk away empty-handed because you’re out of it.This is where inventory software and systems can help you save money and realize more revenues. Technology makes it easy to track inventory. It can notify you when you’re close to running out so you have plenty of time to reorder and your customers never walk away without the products they want.An investment in the right tools can minimize waste and error and may help you generate more revenue.Recommended: 5 Business Financial Software Options

The Takeaway

Your debt-equity ratio is just one useful tool in the overall understanding of your business’s health. It tells you if there's enough owner’s equity to pay off debts if your company were to face a decrease in profits.For lenders and investors, a high ratio means a riskier investment because the business might not be able to produce enough money to repay its debts. A very low debt-equity, however, isn't necessarily ideal either. If the ratio is close to zero, it can mean that the business hasn't relied on borrowing to finance operations and, as a result, isn't realizing the potential profit or value it could gain by borrowing and increasing operations.If you’re thinking about growing your business through leverage, Lantern by SoFi can help. With our online debt financing marketplace, you can explore small business loan options without scouring the web or making any type of commitment. With one short application, you’ll be matched with a loan offer that meets your company’s needs and qualifications.Let Lantern help you find the right financing solution for your small business.

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About the Author

Susan Guillory

Su Guillory is a freelance business writer and expat coach. She’s written several business books and has been published on sites including Forbes, AllBusiness, and SoFi. She writes about business and personal credit, financial strategies, loans, and credit cards.

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