App version: 0.1.0

Debt Equity Ratio for Small Businesses

Debt Equity Ratio for Small Businesses; Debt-to-equity (D/E) ratio is used to calculate how much debt a company has relative to its equity.
Susan Guillory

Susan Guillory

Updated May 19, 2021
Share this article:
Editor’s note: At Lantern, we strive to help you make financial decisions with confidence. To do this, we occasionally feature content that includes information about our partners and their products or services. We do not provide, endorse, or guarantee any third-party product, service, information or recommendations—and our opinions are our own.
Part of cash management for business is understanding how much debt your business is using in relation to equity (or investment). 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. The D/E ratio considers primarily long-term debt (with a repayment schedule longer than one year) for the debt part of the equation, in addition to the interest due on that debt. Sometimes these debts are referred to as liabilities.For small businesses that don’t have shareholders, that “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 simple. Figure out your businesses total liabilities, including long-term loans and any business mortgage it may have. Then figure out how much money is invested (by you or by shareholders) in the business. Then you can use the following formula to arrive at your D/E ratio. Total liabilities/equity (or investment) = 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). If you were looking for investors, they would probably  be pleased with this number. They would likely assess the risk of your not providing a return on investment was very low, making your business an appealing prospect.Here’s another way to look at the D/R ratio. The ratio indicates how much of every dollar of equity goes toward debt. A ratio of 0.1 means that for every dollar of investment you’ve put into your business, you’re spending $0.10 on paying back debt. When that ratio creeps up to $0.75 of each dollar, your company is seen as riskier because it may be more challenging for you to pay back such a large amount of debt in relation to equity.

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  in regards to paying back its debt. Taking on a business loan can certainly provide the opportunity to grow your business, but if the cost of that debt outweighs the financial benefit it’s creating, then your business becomes a risk, since there's a greater chance that you won’t be able to pay back what you’ve borrowed.Potential investors typically want to work with companies that show positive growth regardless of debt. That means that the debt to equity ratio is what they’ll look at, along with other financial ratios, to determine the risk your company might present to them in terms of not receiving a strong return on investment if they bought equity in your company.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.The key to understanding the debt to equity ratio is to compare it 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 an important component of understanding what cost of capital is. While debt can be handy for covering costs when you don’t have cash stockpiled, it can also 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.

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, the more it will cost you in interest and fees. 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.

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.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 cant 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.

4. Work on Revenue-Building Activities

If you can’t cut debt, you may be able to work on building 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

Another strategy is to find 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.

The Takeaway

Your debt equity ratio is just one useful tool in the overall understanding of your business’s health. Whether you want the information for your own use or you plan on applying for financing or you intend to take on investors, it’s a solid metric for understanding whether the amount of debt you have is healthy or is putting your business at risk.But don’t stop with your debt to equity ratio! You can also calculate cash flow, gross profit margin, and other metrics to build your strategy for future growth.Be smart about your small business financing, too. Compare offers and rates from multiple lenders with Lantern.
The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.SOLC21016

About the Author

Susan Guillory

Susan Guillory

Susan Guillory is the president of Egg Marketing, a content marketing firm based in San Diego. She’s written several business books, and has been published on sites including Forbes, AllBusiness, and Cision. She enjoys writing about business and personal credit, financial strategies, loans, and credit cards. Follow her on Twitter @eggmarketing.
Share this article: