When you are operating your business on a daily basis, you may not have time to stop and consider how your company is doing. When you have customer demands that you must meet regularly, you may assume that everything is going along swimmingly. However, whether your business is doing well is measured by more than just how busy you are. Your financial records will tell the true story of the health of your business. One of the most often-used measurements to assess the health of your business is your debt-to-equity ratio.
What Is a Debt-to-Equity Ratio?
Your debt-to-equity ratio is calculated by dividing your total liabilities by your shareholder equity. You can find these numbers on your balance sheet if you are creating regular financial statements (and you should!). This ratio is a good way to measure risk.
- Liabilities include any debt that your company owes to anyone else. It often involves things like long-term loans with financial institutions and any account payable that your business may have, including things like supplies bought on credit and wages payable. It includes both short term and long-term debt.
- Equity is the value of the shares in a company. In a corporation, for example, equity is the total worth of every owner’s stock. If you are a sole proprietorship, on the other hand, your ownership is the whole value of the company minus any liabilities you may have.
Consider an example. Imagine you and a partner have a business together. You both own half of the stock of the corporation. A business valuation expert states that your company’s assets are worth $500,000. You also have about $250,000 in liabilities. The total equity for the company, then, is $250,000. The equity for each individual owner (often called “owner’s equity”) is $125,000.
You can also figure your debt-to-equity ratio using this example, too. In this case, you take the total debt, $250,000, divided by $250,000, to get a debt-to-equity ratio of 1. This number shows how much the business assets are leveraged.
What Does the Debt-to-Equity Ratio Mean?
A debt-to-equity ratio is important because it shows how much your company relies on borrowed funds to support itself. For lenders, it is one of the most important metrics to consider when you apply for a new loan or line of credit. Businesses with lower debt-to-equity ratios will usually have a lower likelihood of default on a new loan, which financial institutions like for obvious reasons.
Taking on debt is inherently risky, which means that the lower your debt-to-equity ratio, the better. However, businesses often take on new liabilities because they are taking advantage of opportunities for growth, which can increase profits over time. They may also take on debt simply to break into a particular industry or field. Taking on debt allows business owners to use smaller amounts of money to fund things like expansions, new product lines, and other opportunities.
What Is a Good Debt-to-Equity Ratio for My Business?
Unfortunately, there is no concrete answer to this question. A good debt-to-equity ratio will vary by industry. For example, businesses that have significant assets may have higher debt-to-equity ratios because they frequently have to take on debt to make large equipment purchases. When there is a substantial investment to get into a particular industry, that category of businesses as a whole is likely to have a higher average debt-to-equity ratio.
As a rule, however, you should try to have a debt-to-equity ratio that is less than 2. That means that you should have less debt than twice as much as your company is worth. On the other hand, for some companies, having a debt-to-equity ratio higher than zero is unheard of—and that may be appropriate for the industry.
Your debt-to-equity ratio will also vary based on your comfort with risk as well. It is riskier to have high debt amounts because there is a chance that you suddenly do not have the funds to pay your ongoing debt obligations.
What Type of Debt-to-Equity Ratio Is Appropriate for My Industry?
CSIMarket, an independent financial research company, has debt-to-equity ratios set out by sector. They provide an average of all companies that they research and place them into broad categories based on their industry.
For example, the services industry will generally have the lowest debt-to-equity ratio. This is, in large part, because their companies often have very few assets to leverage. The average services debt-to-equity ratio is only 0.18. In comparison, utility companies have a debt-to-equity ratio of 13.88 on average.
Aswath Damodaran, a professor at the Stern School of Business at New York University, also keeps a running list of various industry averages based on a relatively small sample of companies, including debt-to-equity ratios. His data is helpful because it breaks out industries further than CSIMarket. According to Professor Damodaran’s data, debt-to-equity ratios (expressed as a percentage) range from .0241 for Internet Software Companies to 10.3023 for Financial Services businesses.
What Does my Debt-to-Equity Ratio Say About My Business’s Health?
High debt-to-equity ratios could signal problems in your business. High rates will indicate to a bank that you are a risky investment and that you may not be able to repay your debts effectively.
However, you should keep in mind that your ratio will vary by industry. That means that you should look to the average in your industry instead of comparing it to the average rate of 2 across all businesses. Ratios will vary over time as well. In market downturns, ratios are likely to be higher across the board.
It is also a good idea to watch your ratio as it develops over time. If you notice that your rate is creeping up, you may need to take a look at why that is happening. Are you taking on too much debt on a regular basis? Have your assets decreased to support that debt? Gradually increasing debt-to-equity ratios are common, but you should keep an eye on it, so it does not get out of control.
If you want to learn more about how your debt-to-equity ratio affects your business’s health today and tomorrow, Dechtman Wealth Management can help. We offer various financial services that will help you determine if you are setting yourself up well for your future. After all, your business is an investment, and it may be one of the biggest ones you have—let Dechtman Wealth Management help you take care of it.
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