Debt-to-equity ratio: How to calculate and improve yours

You’re in the final rounds of securing a crucial investment for your business. The presentation is prepped, the numbers are promising, and, then, the investor throws a curveball. They want to discuss your debt-to-equity ratio. 

Are you confident enough to have this conversation?

Ignoring the meaning of debt-to-equity ratio (D/E ratio) is not an option. This metric, often a deciding factor for investors and lenders, provides a snapshot of your company's financial leverage – the balance between debt and equity fueling your operations. It’s the comparison between what you owe and what you’re worth.

Generally speaking, the higher the D/E ratio, the more concern it raises. It’s a red flag that, from an investor’s standpoint, can mean capital investment is at significant risk. Conversely, a conservative low ratio could indicate you’re not pushing the envelope enough when it comes to growth strategies.

Keep reading to demystify this essential metric, learn how to calculate and interpret it, and discover tips for optimizing your D/E ratio.

What is the debt-to-equity ratio?

The debt-to-equity ratio is a financial metric that compares a company's total debt to its shareholder equity. In essence, it illustrates how much a company relies on borrowed funds versus funds invested by its owners. The ratio is expressed as a decimal or a percentage, providing a clear picture of a company's financial structure and risk profile.

Your D/E ratio, simply put, reveals the balance between these two vital components:

• Debt: The money your company has borrowed from external sources, such as bank loans, lines of credit, or issued bonds
• Equity: The money invested directly into your company by you, your co-founders, or other investors

For instance, a D/E ratio of 0.5 indicates that for every $1 of equity, your company carries $0.5 of debt.

Why is the debt-to-equity ratio important?

The debt-to-equity ratio is often seen as a measure of financial risk. A higher ratio generally indicates greater risk, suggesting a company is relying heavily on borrowed money to expand.

However, during this expansion phase, a higher D/E ratio can be a strategic decision, enabling rapid scaling that might not be possible with solely internal funds or equity investments.

Let's say your eCommerce business specializes in selling handcrafted, high-end furniture, and you're looking to expand into several lucrative international markets.

Scenario 1: High debt-to-equity ratio

To launch quickly in those new countries, you take out substantial loans to cover setting up international shipping. You run marketing campaigns tailored to each region and secure a small warehouse overseas to handle inventory closer to these new customers. This rapid, debt-fueled approach might lead to a 3.0 ratio, for example.

The good

You could capture market share quickly and see a quick increase in sales by establishing your brand in those new countries before competitors catch on.

The risk

International trade expansion has a steep learning curve. If those new markets don't respond as strongly as expected, or you encounter unexpected costs with shipping logistics or cultural nuances in marketing, those large loan payments could become a significant burden on your business.

Scenario 2: Low debt-to-equity ratio

You choose a more measured approach to cross-border expansion. You reinvest some profits, secure a smaller loan, and partner with an investor who has experience helping eCommerce businesses expand globally. They provide capital in exchange for a share of your company. This more cautious approach might result in a ratio closer to 1.0.

The good

You have less debt weighing you down, giving you more flexibility to adapt your strategies as you learn the nuances of each new market. It also tends to be more attractive to investors who understand the complexities of international growth and are in it for the long haul.

The risk

Your expansion will be slower, potentially giving competitors an edge in establishing their brand presence in those new markets. You might miss out on early opportunities to capitalize on high demand while it's still untapped.

What is the debt-to-equity ratio formula?

Calculating your D/E ratio is surprisingly straightforward. Here's the equation:

Debt-to-Equity Ratio = Total Debt / Total Equity

To break it down further:

• Total debt: All short-term and long-term debt obligations, such as bank loans, credit lines, bonds, and any other borrowed funds
• Total equity: The value of the owner’s stake in the company, including common stock, preferred stock, retained earnings, and any additional paid-in capital

Where do you find this information?

Your company's balance sheet, a fundamental financial statement, provides all the data you need to calculate your D/E ratio.

Debt-to-equity ratio example

Let’s say your company, a rising star in the tech industry, has:

• Total debt: $3 million (a combination of a bank loan and venture capital funding)
• Total equity: $2 million (representing investments from founders, angel investors, and a recent funding round)

Using the formula, your D/E ratio would be:

• Debt-to-Equity Ratio = $3,000,000 / $2,000,000 = 1.5

Essentially, this ratio tells you that for every $1 of equity in the company, there is $1.50 of debt.

How to calculate the debt-to-equity ratio in Excel

Microsoft Excel offers a straightforward way to calculate the debt-to-equity ratio. 

Here's an easy approach using Excel:

1. Access your balance sheet: Start by locating your company's most recent balance sheet. This financial statement will provide the necessary data points for your calculation
2. Identify key figures: On your balance sheet, find the total debt and total shareholder equity figures
3. Input data into Excel: Open a new Excel spreadsheet and enter the following: In cell B2, input the value for "total debt." In cell B3, input the value for "total shareholder equity"
4. Apply the formula: In cell B4, enter the following formula: =B2/B3
5. Calculate your ratio: Hit "Enter," and Excel will instantly calculate and display your D/E ratio in cell B4

You've crunched the numbers and the debt-to-equity ratio calculation. Now, the million-dollar question: What does that number actually mean for your business?

What is a good debt-to-equity ratio?

A "good" debt-to-equity ratio isn't one-size-fits-all. It depends heavily on the industry and the specific company's circumstances. A commonly cited range for a healthy D/E ratio is between 1 and 1.5. 

However, capital-intensive industries, such as manufacturing, finance, and mining, often have naturally higher ratios. These businesses require significant upfront investments in equipment, infrastructure, or resources. That said, ratios above 2.0 are more common in these sectors.

A debt-to-equity ratio consistently above 2.0 might raise a red flag, signaling potential financial risk. Again, though, you must consider the company's industry peers and its historical ratios before drawing conclusions.

When evaluating a company's D/E ratio, it's essential to:

• Compare within the industry: Look at competitors and the industry average to understand what's considered normal
• Analyze trends: Has the company's ratio been increasing or decreasing? Significant changes warrant further investigation
• Consider the stage of the business: A rapidly growing company might have a temporarily higher ratio as it invests in expansion

Learn more: 5 tips for securing the capital you need to scale your business.

How do you fix a high debt-to-equity ratio?

If your company's debt-to-equity ratio is too high, it's essential to take steps to reduce it and improve your financial health.

1. Increase revenue and equity

One of the most effective ways to lower your debt-to-equity ratio is to increase revenue. As your company generates more income:

• Pay off debts: Allocate a portion of the increased revenue towards paying down existing loans, reducing your overall debt burden
• Invest in assets: Use the funds to purchase new assets that can further fuel growth and profitability, strengthening your equity position

2. Improve inventory management

Inventory ties up a significant amount of working capital. Inefficient inventory management can lead to wasted resources and negatively impact your D/E ratio.

• Optimize inventory levels: Implement inventory control techniques to strike a balance between meeting customer demand and minimizing excess inventory
• Enhance forecasting accuracy: Use historical sales data, market trends, and forecasting tools to predict demand more accurately, reducing the risk of overstocking or stockouts

3. Pay down loans strategically

Develop a focused debt repayment plan to reduce your liabilities effectively:

• Prioritize high-interest debt: Target loans with the highest interest rates first to minimize your overall interest expense over time
• Explore refinancing options: Research opportunities to refinance existing debt financing at lower interest rates, reducing your monthly payments

4. Restructure debt for manageable payments

If you're facing challenges meeting debt obligations, consider restructuring options:

• Negotiate with lenders: Communicate openly with your creditors to explore possibilities for modifying loan terms, such as extending repayment periods or requesting temporary forbearance
• Consider debt consolidation: Combining multiple debts into a single loan can simplify repayment and potentially secure a lower average interest rate

5. Consider alternative financing

Traditional loans aren't the only way to access capital. If you have a significant amount of cash tied up in unpaid invoices, invoice financing can provide an alternative. 

By selling your outstanding invoices to a third-party lender (a factoring company) at a discount, you receive immediate cash. The lender then takes on the responsibility of collecting payment from your customers. 

As an alternative financing, invoice financing is generally not considered debt in the traditional sense because you’re selling an asset (the invoice) rather than taking on a loan. It doesn't directly increase your liabilities, making it a favorable option for improving your debt-to-equity ratio.

Learn more: Everything you need to know about invoice financing.

When to use debt-to-equity ratio?

The debt-to-equity ratio is a valuable tool for assessing a company's financial leverage and risk. It plays a crucial role in securing funding for small businesses, as both investors and lenders may use it to assess a company's financial health and potential for returns.

Beyond attracting capital, the D/E ratio provides a benchmark for understanding a company's financial structure compared to its industry peers. This comparative analysis can reveal whether a company's reliance on debt is standard or indicative of potential vulnerabilities.

Regularly monitoring the debt-to-equity ratio also allows businesses to track their financial health over time. An ongoing analysis can serve as an early warning system, prompting adjustments to financial strategies if concerning trends emerge.

Finally, the D/E ratio is a powerful tool for making informed decisions that support sustainable growth and long-term financial stability.

Access growth funding without increasing your debt burden

So your debt-to-equity ratio has got you feeling a little… restrained? And those traditional banks? Let's just say they haven't quite entered the 21st century. 

You need capital that's as agile and ambitious as you are, not another loan application stuck in financial quicksand.

Meet Stenn: we’re the next-gen capital platform built to help businesses like yours break free and scale. Get up to $100 million in days, all without adding a single cent of debt to your balance sheet.

The secret? Invoice financing. We unlock the power of your unpaid invoices, turning those receivables into revenue you can use right now. It's time to leave slow-paying clients in the dust and seize your next big opportunity.

Ready to break free from the debt cycle and fuel your future? Get funded with Stenn.