When people start talking about the financial health of a company, they often start talking about ratios – one that often comes up is the Debt to Equity Ratio. The debt to equity ratio is a measure of leverage. Sometimes you will hear about companies being over-leveraged – this is scary. It means that they owe too much and don’t own enough.
If you are a small business owner, you may think that this has nothing to do with you, but what if you need to borrow? Suddenly your debt to equity ratio becomes very important. The banks will take a look at this before they decide whether or not to lend to you. If the number is too big, you will be too big a risk for the bank. They will not lend to you if they think that you will not be able to pay them back.
The Math
So how do we make the number? Take all of your debt, that means loans, lines of credit, accounts payable, and taxes payable and add that together to get the top number. Next take all of your equity – this number can be calculated by adding up all of your assets (equipment, accounts receivable, cash, etc.) and subtracting the debt amount from it. This will be the bottom number.
Now divide the top number by the bottom number and you will get your Debt to Equity Ratio.
The Meaning
I know what you are thinking – great, now I have a number and I have no idea whether or not it is good or bad. What is the “right” number? This is a complex question. There are different numbers for different industries. If you are in a very equipment heavy industry like some kind of manufacturing, then you will have a bigger number because of all of the physical assets that you purchase with borrowed money. If you are an app development company that has little in the way of tangible assets, you will probably have to raise a lot of your money through investment and your number will be lower.
Whether you are seeking lending or investment, you should have a good idea of what your Debt to Equity Ratio is and how that compares to others in your industry.
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