The debt-to-equity ratio measures your company’s total debt relative to the amount originally invested by the owners and the earnings that have been retained over time.
The debt-to-equity ratio of your business is one of the things the bank looks at to assess your situation before agreeing to lend you an additional amount.
Examples of debt-to-equity calculations?
Let’s say a company has a debt of $250,000 but $750,000 in equity. Its debt-to-equity ratio is therefore 0.3. “It’s a very low-debt company that is funded largely by shareholder assets,” says Pierre Lemieux, Director, Major Accounts, BDC.
On the other hand, a business could have $900,000 in debt and $100,000 in equity, so a ratio of 9. “In a case like that, the lenders almost completely financed the business,” says Lemieux.
Typically, the debt-to-equity ratio falls between these two extremes.
Example of a debt-to-equity ratio in a corporate balance sheet
| LIABILITIES | ||
| Current liabilities | ||
| Accounts payable | 250,000 | |
| Current portion of long-term debt | 15,000 | |
| Total current liabilities | 265,000 | |
| Long-term liabilities | ||
| Long-term debt | 1,500,000 | |
| Amounts payable to related parties | 100,000 | |
| Total long-term liabilities | 1,600,000 | |
| TOTAL LIABILITIES | 1,865,000 | |
| SHAREHOLDERS’ EQUITY | ||
| Common shares | 100 | |
| Preferred shares | 250 | |
| Retained earnings | ||
| Opening balance of retained earnings | 540,000 | |
| Current period income | 125,000 | |
| Dividends paid | (45,600) | |
| Closing balance of retained earnings | 619,400 | |
| TOTAL SHAREHOLDERS’ EQUITY | 620,000 | |
| Debt-to-equity ratio | 3.01 |
How to interpret a debt-to-equity ratio?
The goal for a business is not necessarily to have the lowest possible ratio. “A very low debt-to-equity ratio can be a sign that the company is very mature and has accumulated a lot of money over the years,” says Lemieux.
But it can also be a sign of resource allocation that is not optimal. “There is no doubt that the level of risk that shareholders can support must be respected, but it is possible that a very low ratio is a sign of overly prudent management that does not seize growth opportunities,” says Lemieux.
He also notes that it is not uncommon for minority shareholders of publicly traded companies to criticize the board of directors because their overly prudent management gives them too low a return.
“For example, minority shareholders may be dissatisfied with a 5% capital gain because they are aiming for 15%,” says Lemieux. “To get to 15%, you can’t sit on a lot of money and run the business super-prudently. The company has to invest in productive resources using debt to leverage.”
What is a good debt-to-equity ratio?
Although it varies from industry to industry, a debt-to-equity ratio of around 2 or 2.5 is generally considered good. This ratio tells us that for every dollar invested in the company, about 66 cents come from debt, while the other 33 cents come from the company’s equity.
“This is a very low-debt business with a sound financial structure,” says Lemieux.
What is a bad debt-to-equity ratio?
When the ratio is more around 5, 6 or 7, that’s a much higher level of debt, and the bank will pay attention to that.
“It doesn’t mean the company has a problem, but you have to look at why their debt load is so high,” says Lemieux. “If it has just invested in a major project, it is perfectly normal for its ratio to rise. Then the company will make a profit on its investment and its ratio will tend to fall to more normal.”
It’s also important to note that some industries naturally require a higher debt-to-equity ratio than others. “For example, a transport company has to borrow a lot to buy its fleet of trucks, while a service company will practically only have to buy computers,” explains Lemieux.
Where do you find the average debt-to-equity ratio in your industry?
To do benchmarking, you can consult various sources to obtain the average for your business sector.
BDC provides access to benchmarks by industry and firm size to its clients. This data is also available from some private companies. University research centres can also be a good source of information.
What is the long-term debt-to-equity ratio?
It’s the same calculation, except that it only includes long-term debt. So, for example, you subtract the balance on the operating line of credit and the amounts owed to suppliers from the liabilities. “By keeping only the long-term debt, it is more revealing of the company’s true debt level,” says Lemieux.
While for some businesses, eliminating short-term debt does not make a huge difference to the end result, for others, it is major.
“Some types of businesses, such as distributors, need to have a lot of inventory, which adds to their debt,” says Lemieux. “However, those amounts are paid off as the company makes its sales. It has nothing to do with loans from the bank.”
Some banks use this ratio taking long-term debt, while others keep total debt.
Is the debt-to-equity ratio widely used by banks?
According to Pierre Lemieux, the debt-to-equity ratio is interesting because it can be easily tracked from month to month. However, he noted that its use is decreasing.
“It’s a balance sheet-only ratio,” he says. “It does not look at the funds generated by the company, that is, the cash flow. For example, a company that has $1 million in after-tax profits and another that benefits from its good years in the past and that now has a net loss of $1 million annually can have the same debt ratio. However, the former would be in a much better position to repay its debt than the latter.”
The interest-bearing debt (IBD) to earnings before interest, depreciation and amortization (EBITDA) ratio
Lemieux explains that the IBD to EBITDA ratio is increasingly used because it compensates for weaknesses in the debt-to-equity ratio by taking into account a company’s cash flow and excluding its non-interest-bearing debt (such as accounts payable and amounts owed to the government).
“This ratio looks at the company’s balance sheet, but also its cash flow. It thus enables the bank to better assess the company’s ability to repay its debt.”
However, he notes that it is more difficult to track the IBD/EBITDA ratio on a monthly basis.
“Normally, it is calculated at the end of the fiscal year,” says Lemieux. “It is also calculated on an interim basis, but a 12-month rolling window must then be used. To calculate it, say in April, you have to look at the company’s numbers for the previous 12 months, starting in May of the previous year. Not all businesses are equipped to pull out this data.”
So while the debt-to-equity ratio is not perfect, the others are not perfect either. That is why it is advantageous for businesses and financial institutions to pay attention to the different ratios.
Download our free guide Monitoring Your Business Performance for more information on key ratios for managing your business.
