What Is a Good Debt-To-Equity Ratio and How It Benefits Your Business
When lenders or potential investors review your business, they look at a few key pieces of financial information. The debt-to-equity ratio is one important figure, because it's a sign of whether you can keep up with your bills. Understanding how to maintain a good debt-to-equity ratio can help you improve not only your access to financing but your overall business operations.
What is a debt-to-equity ratio?
The debt-to-equity ratio is a calculation that divides your business' total outstanding debts by its current equity. Both these figures should be listed on the balance sheet in your financial statements.
If you don't have this information already, you can figure out your equity by adding all up your assets—everything your business owns—and then subtracting your liabilities, everything you owe. The difference is your equity, the value of your business left for the owners if you sold everything today and paid off your debts.
For example, a business has $2 million in assets and $1 million in total liabilities, which makes its equity $1 million. Their debt-to-equity ratio is 1:1.
Why it's important for businesses
The debt-to-equity ratio shows how much of your company has been funded using debt versus how much has been funded through equity, using investors and company profits. Debt is a riskier form of funding because you're required to keep up with the scheduled loan payments—it's not optional like paying a profit dividend to shareholders. If you miss payments, the creditors could take you to court, seize your assets and potentially even bankrupt your company.
Maintaining a good debt-to-equity ratio can help your financial stability. It's a sign you can manage your debt payments and that you still have room to borrow. In other words, you haven't maxed out your credit limits. A good ratio can also help you qualify for other loans and bring on investors. If your debt-to-equity ratio is too high, lenders and investors might find your business too risky to invest more money in.
Understanding your ratio
The benchmark for a good debt-to-equity ratio depends partly on your industry. If you run a business that doesn't require much physical equipment, like a software firm, it's common to expect a lower debt-to-equity ratio—typically below 2:1. On the other hand, manufacturers typically have higher debt-to-equity ratios because they need to borrow more for equipment, machines, buildings and other physical assets.
You should check the industry average for your type of business to figure out a good debt-to-equity ratio. A 3:1 ratio might be considered too high for a software company but reasonable for a manufacturer.
It's also possible to have too low a ratio. If your ratio is well below 1:1, investors might be concerned that you aren't actively growing your business with debt or that you've sold off too much equity to other investors. An ideal debt-to-equity ratio is based on balancing both types of financing.
How to improve
If you're worried about your debt-to-equity ratio, one way to trim it down is by paying off debt. While that might be easier said than done, it's the simplest way to lower your ratio. It's also helpful to calculate whether it makes sense to consolidate your debt. Consider working on your ratio especially before you apply for a new loan or try to bring on investors.
You should also remember that not all debt is equal in risk. High-interest, unsecured debt like a credit card is more expensive and riskier than a secured equipment loan with a lower interest rate. Investors and lenders could be more accepting of a higher ratio if it's from safer debt, so prioritize paying off unsecured loans.
You should also pay attention to your ratio over time. If it seems to be creeping up, ask yourself whether that was from planned borrowing or from a growing financial issue. The earlier you catch potential debt trouble, the easier it is to keep it from spiraling.
Working toward the right debt-to-equity ratio for your business is less about the exact number and more about making sure you can keep up with your debt payments, based on current income and equity. A tax professional or business banker can help you plan for a strategy to improve your ratio and better understand your financial metrics.
Financial insights for your business
This information is provided for educational purposes only and should not be relied on or interpreted as accounting, financial planning, investment, legal or tax advice. First Citizens Bank (or its affiliates) neither endorses nor guarantees this information, and encourages you to consult a professional for advice applicable to your specific situation.