As you work to grow your startup, you’ll need to secure investment capital. Whether it’s hiring employees, renting a suitable office space, launching a new product, or one of the many other ways your business must spend to grow, you’ll need to obtain the funds before you can put them to use.
There are a few ways to raise capital, but the two most common are debt and equity financing. While debt is often seen as a negative in personal finance (which itself isn’t an entirely accurate view), it’s often necessary and even beneficial for a business to finance its activities with borrowed funds.
You’ll almost certainly employ a combination of both debt and equity when gathering funding for your business, but it’s important to be mindful of how much you’re relying on each in relation to the other.
There’s a lot of room for complexity and nuance when it comes to the specifics of your company’s debt, total equity, and their relation to one another, but your company’s basic debt-to-equity ratio is one of the calculations financial analysts, potential investors, and creditors will invariably look at to assess its financial health.
Below we’ll show how to calculate debt-to-equity ratio, take a look at what an ideal debt-to-equity ratio might look like, and explain why it’s an important metric for you to keep an eye on as you grow your startup.
A Few Terms You’ll Need To Understand To Calculate Debt-To-Equity Ratio
Before we get into the math of debt-to-equity ratio, let’s clearly define a few terms to start with a clear understanding of the numbers:
Debt-to-equity ratio is a financial metric that provides insight into a company's financial leverage, found by comparing the company’s total liabilities and total shareholders’ equity. It is expressed as a single number that represents how many dollars of debt a company owes for every one dollar of equity it possesses. The more debt a company uses, the higher the company’s debt-to-equity ratio will be.
Leverage describes a business’s use of debt to finance assets and increase the potential return on an investment. In practice, you might hear a company that relies on debt heavily as a way to finance its business activities and purchase the company’s assets—and likely has a higher debt-to-equity ratio—as “highly leveraged.” Several leverage ratios can assess the financial health of a business, but debt-to-equity ratio is the most well-known and commonly referenced.
Debt—in this case—is synonymous with liabilities and means any amount of money your business is obligated to pay another entity, including but not limited to vendors, government agencies, and employees. This includes both short-term and long-term debt:
- Short-term debt includes financial obligations that are due within a 12-month period. Short-term debt can include outstanding invoices, utility bills, deferred taxes, wages due to contractors or employees, and income taxes payable.
- Long-term debt includes financial obligations that extend beyond 12-months. Long-term debt can include business loans, mortgages, leases, equipment rentals, and pension obligations.
Shareholders’ equity is the value attributable to the owner(s) of a business.
See also: How to Calculate Startup Burn Rate: Cash Burn vs Gross Burn vs Net Burn
How To Calculate Debt-To-Equity Ratio
Now that we’ve defined the terms, let’s look at how to find debt-to-equity ratio. Fortunately, finding this financial metric is very simple mathematically, and you can easily find all the information you need for the calculation in your firm’s balance sheet.
The debt-to-equity ratio formula is:
Debt-To-Equity Ratio = Company’s Total Debt / Shareholders’ Equity
For example, if your startup owes $30,278 to third parties and has $19,803 in shareholder equity, you’d find your debt-to-equity ratio by dividing your debt by your shareholder equity as follows:
$30,278 / $19,803 = 1.53
So, in this case, your debt-to-equity ratio is 1.53—in other words, your business owes third parties $1.53 of every $1 of shareholder equity. (Note: Debt-to-equity ratio usually isn’t expressed as a percentage.)
See also: How To Read a Balance Sheet
What’s an ideal debt-to-equity ratio?
Like other leverage ratios, outside parties—usually lenders and investors—use your company’s debt-to-equity ratio to assess the risk level of lending to or investing in your business. Very broadly speaking, a debt-to-equity ratio between 1 and 1.5 is usually considered good debt, while a ratio exceeding 2 is considered high risk.
That said, the ideal ratio for your business depends largely on the industry in which it operates. To get a sense of norms across a wide swath of businesses, check out this breakdown of median and average debt-to-equity ratio by industry.
As you may notice, industries with high levels of fixed assets, like air travel, rail travel, and coal mining, have significantly higher debt-to-equity ratios than most others, as they must make large purchases of land, facilities, and machinery to operate and often finance those purchases with debt. These industries also tend to be dominated by very large and profitable companies that can easily fulfill their debt obligations.
In general, lower is better.
Generally speaking, both lenders and investors tend to prefer businesses with lower debt-to-equity ratios. For lenders, a lower ratio means the borrower is able to manage their financial obligations and more likely remain capable of paying back the money they’ve loaned to it. For investors, a lower ratio means a lower cost of debt, and signals a company has a lower risk of bankruptcy and greater chance of success.
But there is such a thing as too low.
Maintaining the lowest possible debt-to-equity ratio isn’t necessarily the best course of action either though, especially when it comes to attracting shareholders looking for the greatest return possible on their investment. An abnormally low ratio in the context of your industry can be a sign of bad management, specifically, a failure to utilize debt as a tool for growth and thus indicate your business is a higher risk investment.
Additionally, in extreme cases, a company could have a negative debt-equity ratio, but this means the company is operating at a loss and is unlikely to be an appealing prospect to lenders or investors.
The importance of debt capital
Debt is an important and useful resource for businesses, as it allows them to leverage a small amount of money or earnings into a much larger amount, leaving a net positive even after they’ve paid the debt. For example, if a manufacturing company is producing a profitable product at capacity and still unable to fulfill the existing demand, taking out loans (“good debt”) to purchase more warehouse space and machinery would further accelerate the rate at which profits increase and increase shareholders’ value.
An unusually low debt-to-equity ratio can be a sign to investors that management isn’t seizing such opportunities and is failing to maximize shareholders’ return on their investment.
Putting your debt-to-equity ratio into context
Though your business’s debt-to-equity ratio is important, especially when you’re seeking a loan or courting potential investors, it’s one among many factors that determine your company’s financial health and attractiveness to lenders and investors. Your product, your team, market conditions, and myriad other factors also go into their analysis of your startup.
To determine if your debt-to-equity ratio is suitable for your industry and place it in the context of other important financial considerations, your best course of action is to consult with an experienced financial advisor.
Zeni can help you and your business navigate the world of startup finance.
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