If you’ve ever looked at obtaining financing for your business, you’ve likely heard of the debt-to-equity ratio. But, what is it? And, what does it mean to lenders? Here’s what you need to know about debt-to-equity ratio.
What is debt-to-equity ratio?
The debt-to-equity ratio compares a company’s total amount of debt to its total amount of equity and is used to show how much of a company’s financing comes from lenders. In simple terms, it is your debt divided by your total equity.
All of the elements of a debt-to-equity ratio can be found in your company’s balance sheet. To calculate the ratio use this formula:
Debt-to-Equity Ratio = Total Liabilities ÷ Total Equity
Consider this example:
Your balance sheet is made up of $500,000 in Assets (cash, AR, fixed assets, etc.), $400,000 in liabilities (AP, Payroll Liabilities, Credit Cards, Bank loan) and total Equity of $50,000. Here is how you calculate the debt-to-equity ratio:
$400,000 ÷ $50,000 = 8
Your debt to equity ratio would be 8. Meaning, you have 8 times more debt than equity.
What this tells a lender:
You (the owner/owners) are using mostly outside money to finance your assets. You are willing to risk the money of others, but not your own. A company with a high debt to equity ratio of can be considered as a risky investment for lenders. A lower debt-to-equity ratio, such as 1, means lenders have an equal stake in your company and implies a more stable business.
Every industry has a different debt-to-equity ratio standards because some need more financing that others. In most financing situations, you’re going to have to put up some of your own money to make the deal work. When this isn’t an option, you may need to look for equity options, where you will give up ownership in lieu of cash.