Debt-to-equity ratio: how to calculate it and why it matters

Debt-to-equity ratio (D/E) is an important metric for business owners. Calculating it will help you assess the financial health of your business, inform your ongoing strategy and help you plan for the future.

Unfortunately, they don’t teach this at school. Unless you studied business management or finance, you might not know about it or have the confidence to work it out. SME owners come from all walks of life and there are plenty who don’t know about D/E.

If you’re here, it means you’re ready to learn (or to get a refresher) – so please read on to get all the information you need. We’ve written this guide to be clear and easy to understand, so everyone can benefit.

 

What is a debt-to-equity ratio?

Your D/E measures your business’ total debts against shareholders’ equity. It’s a quick way to look at your business’ financial health and sustainability, as it shows how reliant on debt you are to keep operating.

More on how to run this calculation shortly.

 

The importance of the debt-to-equity ratio

Not all debt is bad for business. In fact, lots of growing businesses achieve their success, in part, thanks to well-managed debt.

Your D/E is relevant to both the present and future of your business, so it’s worth calculating and keeping updated.

 

Significance in assessing financial health

D/E provides a snapshot of a business’ financial health. It’s not perfect, nor does it reflect nuance or detail, but it is a useful metric that is quick and easy to calculate.

A high or low D/E (which we’ll explain in more detail shortly) can mean different things for your business. It can reflect high ambitions or a slower approach, or it can just be par for the course of your capital-intensive industry.

High or low, your D/E is a great starting point for assessing your finances.

 

Impact on investors and lenders

Investors and lenders might look at a business’ D/E as part of their due diligence process.

Each party will have its own view on what an acceptable or attractive D/E is, but they’ll be looking to see that your business isn’t:

• Too reliant on debt, or
• Missing opportunities by not taking on enough debt

 

Role in business decision-making

Your D/E can influence short-term and long-term planning. After calculating your D/E, you might think your borrowing rate feels unsustainable and your plans might change.

If your D/E calculation shows you that debt management needs to become the priority, you might have to halt growth projects until you’re on top of your debt.

On the other hand, you might find that you have room to use more debt. This could encourage you into new projects or opportunities.

 

How to calculate your businesses debt-to-equity ratio

The formula to work out your D/E is:

Total debt / shareholder equity

Now, for the most important part: how to actually work out your D/E. If you’ve got an accountant or finance team, you might want to ask for their help to get you the documents and data you’ll need.

 

Understand the formula

It’s a simple formula, but it’s important to understand what we’re putting into it, so that what we get out is accurate.

Constant	Meaning
Total debt	All the money your business owes, whether to other businesses, HMRC, banks, or any other creditors. If you owe £50,000 on a bank loan and £50,000 in a corporation tax bill, your total debt is £100,000.
Shareholder equity	The total value of your business’ assets, minus all debts. For example, if you have £100,000 in debts and £200,000 in assets, your shareholder equity would be £100,000. Shareholder equity can also be called book value.

 

Gather financial data

To run the calculation, you’ll need to have up-to-date figures for your debts and shareholder equity.

Debts and assets are listed on your balance sheet. If you can’t use your current balance sheet, you should instead look to your accounts from the last full financial year.

If you’re trying to calculate another business’ D/E, you can find its balance sheet in their accounts published by Companies House.

 

Identify total debt

Balance sheets typically split total debts across two rows: amounts falling due within one year and amounts falling due after one year.

Both of these figures are debt, regardless of their repayment terms. You’ll need to add them both together to get the total debt.

John Harrison, Allica’s Head of Client Relationship Management, highlights one exception to consider: “director or shareholder loans would count as debt but, in reality, if they are quasi-capital with no pressure to withdraw, they can skew the number. If this is the case, you might want to exclude them.”

 

Identify total equity

If you’ve not calculated shareholder equity before, you’ll need to work out what you’d receive if you sold all of your business’ assets and repaid its debts. Whatever is leftover is your shareholders’ equity, often called the ‘book value’ of your business.

To calculate your shareholder’s equity (or book value), calculate the following:

Total assets - debts

 

Perform the calculation

Once you’ve got all your numbers and are happy they’re accurate (ideally with the confirmation of your finance team/accountant), plug the numbers into the formula and you’ll get your ratio.

For example, let’s say your total debt is £100,000 and your shareholder equity is £80,000.

£100,000 / £80,000 = 1.25

In this example, your D/E is 1.25.

 

Interpret the result

Taken on its own, 1.25 (or whatever your D/E comes out as) doesn’t mean a lot.

How you interpret your D/E depends on the context of your business and industry. What your D/E means for your business (and its investors and lenders) also requires some more analysis.

We discuss all of this in the next sections.

 

What does your debt-to-equity ratio mean?

You’ve gathered your numbers, run the calculation and got your D/E… now what? A number is worthless without a narrative to explain it.

 

Low debt-to-equity ratio

A low D/E is generally considered a good thing, although not in all situations. Some investors might think it reflects unfulfilled potential for growth – possibly even giving competitors the chance to jump ahead as a result.

Every business and situation are unique, but a low D/E indicates:

• Lower financial risk – the business can fund its continued operations from its own cash reserves and isn’t relying on debt to stay afloat

• Greater financial flexibility – the business has room to make capital investments or take on more debt to finance future projects

• Investor confidence – investors can see a low D/E as good or bad, depending on a few factors. On one hand, it shows the business is operating carefully and is self-sustaining. On the other, it could represent missed opportunities and a lack of ambition

 

High debt-to-equity ratio:

While a high D/E is not typically a good thing, some investors might be encouraged by the explanations you can provide alongside the ratio.

If you’ve taken on debt to fund a particular project or to secure an opportunity, they might share your long-term view that your high D/E will eventually be worthwhile.

Typically, a high D/E tends to indicate:

• Higher financial risk – the business is debt-heavy and either taking a risk in its strategy or using debt to stay afloat

• Potential for higher returns – investors could see debt utilisation as part of a calculated strategy for growth. Alternatively, they might plan to turn the business around, using its debts as leverage to takeover at a good price

• Debt servicing pressure – the business might struggle to repay its existing debts or be unable to afford any future borrowing, meaning it’s at its financial limit

 

Comparing your debt-to-equity ratio to industry standards

Now that we understand what high and low D/E mean for businesses, we need to understand how to interpret what counts as high and low.

There’s not a universal rule, as each industry operates in different ways. The baseline changes depending on sector and economic factors, like interest rates.

To work out where your business’ D/E sits compared to its competitors, follow these steps.

 

1) Identify industry benchmarks

Lots of websites report D/E ratios by industry, but these often skew towards the USA, so might not be entirely reliable or relevant for your UK-based SME.

To get your own benchmarks, you can take a multi-pronged approach:

• Download industry reports from banks, trade bodies and consultancies to get a broad view of industry performance

• Use data from Companies House to calculate competitors’ D/E

• Create multiple models for different variables, eg. businesses of a similar size, businesses in your region or businesses that have grown in the last year

• Speak with your accountant to see if they can share anonymised data or have access to benchmarking software

It’s also worth talking to any business owners you know and trust, to gauge their views and experiences with debt-to-equity ratios.

 

2) Consider industry characteristics

No two industries are the same, even if they share a lot in common.

‘High’ and ‘low’ are subjective. Let’s take a D/E of 1.5 and set it in context for three different industries:

Industry	Context	High or low?
Construction	Capital-intensive projects (eg. buying equipment and materials upfront), but for good returns on completion.	Normal
Utilities	Expensive, debt-funded projects, but have highly stable cashflow for repayments.	Low
Tech startup	Lack the established cashflow to repay debts, which is why they tend to rely on equity financing (selling shares).	High

 

3) Assess your position relative to industry

Once you’ve got your benchmarks, calculate your D/E and compare it.

A spreadsheet with all your examples filtered from highest to lowest should do the job.

 

4) Adjust for company-specific factors

As you might have realised by now, context is key. You can benchmark according to different characteristics (eg. high-growth companies or companies with international distribution), but there are always further nuances to consider.

You know your business’ situation in perfect detail, so you can adjust your response accordingly.

 

5) Understand the implications

Now you understand your D/E in context, you must decide whether it’s working for you.

You might see an opportunity to take on more debt to grow or need to pull back a little. It all depends on your plans and what your calculations and comparisons reveal.

As well as observing your D/E in the here and now, it can be worthwhile to compare across years to track trends and how D/E influences performance.

Whatever you uncover, we’ll always recommend discussing the results with your accountant or bank relationship manager. They’ll have an unbiased view on what it means and what actions you might want to take.

 

Key factors that affect the debt-to-equity ratio

Your debt-to-equity ratio is a simple formula, but the context is far more complex. There are lots of factors that influence your D/E for better or worse, some entirely out of your control.

 

Business model and industry standards

Some businesses will always run a higher D/E than others, partly because that’s just how their industry works.

As we explained before, debt isn’t always a bad thing and can actually be essential for some businesses. A real estate developer will struggle without well-managed debt, for example.

 

Company lifecycle stage

Early-stage and high-growth businesses (startups and scaleups) can both face huge capital demands, but approaches to funding them can vary wildly.

A startup might not be able to afford debt repayments while still establishing revenue, so will want to avoid debt to grow and prefer equity financing.

A scaleup business, with established customers and proven success in the market, might be able to afford to use debt as a vehicle for growth.

 

Economic conditions

2020 will have led to changes in D/E for a lot of businesses, due to no fault of their own. A global pandemic threw the economy into chaos and businesses had to turn to government (and bank) loans.

This wasn’t reckless or high-risk, ambitious borrowing. It was necessary for survival.

This is another example of why a high D/E shouldn’t be considered a problem by default. It’s the narrative behind the D/E that really counts.

 

Interest rates

For many businesses, the real pressure with borrowing comes not from the principal but the interest charged. As a result, a big change in interest rates can turn a low D/E into a high one overnight (and vice versa).

In a high interest rate environment, businesses can’t afford to borrow as much. If they’re already overleveraged, it can be fatal.

 

Cashflow

When discussing the D/E formula earlier, we recommended including short-term creditors in total debts. They are debts, however short-term creditors are often quite different from long-term capital loans.

Accounts payable, for example, is as much a normal part of operations and cashflow as it is a debt.

Similarly, accounts receivable can have an impact on D/E – if a company is waiting to be paid for a substantial contract, (some of) that capital could either repay a debt or be added as an asset to increase shareholders’ equity.

 

Profitability

A profitable business with a high D/E can, generally, be considered to be heading in the right direction.

Not only will it be steadily increasing its shareholders’ equity, it’s also clearly doing well and getting things right strategically and operationally.

 

Regulatory environment

A business can find itself in a great or challenging position without doing anything. Changes to regulatory standards and rules can affect a business’ D/E.

This can be industry-specific or universal, for example:

• The Basel Accords – an internationally agreed set of regulations for banks – have changed the rules about how much money banks should hold in their reserves and how much debt they can hold. Individual banks didn’t decide to do this, but it will affect their D/E.

• An increase to the minimum wage, affecting all employers

 

Debt-to-equity: much more than a number

Your debt-to-equity ratio is a simple formula in a crowded, complicated context. The number it produces is just the start of the process.

Understanding your D/E means understanding more than just your balance sheet - you’ll be looking at your wider industry, as well as explaining your unique situation.

It’s a great benchmark to review regularly, revealing some interesting perspectives that you might otherwise miss.

Calculating your D/E and comparing it against benchmarks can be essential for making future plans. You might even catch problems and opportunities before they arise.

Links were live and information was correct at the time of writing the article.