Starting a small business is an adventure, and with it comes the need to get familiar with some financial basics. One term you often hear tossed around is “equity.” Simply put, equity is what you own in your business. Equity is an essential piece of your business’s financial puzzle. However, another important concept is not as complex as it seems: the debt-to-equity ratio.
This guide is designed to break down the debt-to-equity ratio in a way that’s easy to grasp. We will show you why it is a tool worth understanding and how it can help shape your business decisions for the better.
What is the Debt to Equity Ratio?
Ever wondered how to measure the financial health of your business in a simple way? Enter the Debt to Equity Ratio. This straightforward metric shines a light on the balance your business achieves between its debts and the money you or your investors put into the company.
Here’s a quick rundown:
• Debt: This represents all the money your business owes. It includes loans, mortgages, credit lines, or any other form of borrowing. Essentially, it is the total sum of funds that you need to repay to lenders.
• Equity: This is the money invested in your business that does not need to be repaid. It could be your own money that you have put into the company or funds from investors who have bought into your business. Equity represents the ‘ownership’ part of your business finances.
The way these two interact in the debt-to-equity ratio. The ratio is calculated by dividing your total debts by your total equity. This number helps you see the balance between the money you owe and the money invested in your business.
Why is This Ratio Important for Your Business?
To illustrate the significance of the Debt to Equity Ratio and how it can guide strategic decisions, below is a simple chart that categorizes different ranges of the ratio along with descriptions and advice for each level.
Debt to Equity Ratio Chart
Really High (Above 2.0): Your business is significantly leveraged, relying heavily on debt. This scenario necessitates a strong focus on reducing debt or seeking additional equity investors to mitigate financial risk and improve stability.
High (1.5 – 2.0): A high ratio indicates a considerable reliance on debt. In this range, actively working to reduce debt can lead to more profits through lower interest expenses. It’s a sign to reassess financial strategies to ensure long-term sustainability.
Medium (0.5 – 1.5): This is generally considered a healthy balance between debt and equity. It suggests that your business is utilizing a balanced approach to financing, leveraging both debt and equity efficiently. This is a good position that offers flexibility and stability.
Low (0.2 – 0.5): A low ratio indicates a conservative approach to leveraging debt, with a stronger reliance on equity. While financially stable, businesses in this range might consider using debt strategically for expansion or growth opportunities to maximize returns.
Really Low (Below 0.2): This suggests that your business is under-leveraged and might be missing out on opportunities for growth that could be financed through loans.
Each of these ranges offers a snapshot into a business’s financial leverage and risk position, providing a starting point for deeper analysis and strategic planning. Understanding where your business falls on this spectrum empowers you to navigate debt and equity management more effectively.
Calculating the Debt to Equity Ratio
To give you a clearer picture of what this number means and how it can be applied to your business, here is an example and breakdown of the calculation process:
1. Add up all the debts your business owes. This includes business loans, mortgages, and any other borrowings.
2. Determine your business’s total equity. This is what you and any other investors have put into the company.
3. Divide the total debt by the total equity.
For example, if your business has $50,000 in debt and $100,000 in equity, your Debt to Equity Ratio is 0.5 (50,000 ÷ 100,000).
Everyday Scenarios
To make this more relatable, here are some scenarios you might encounter:
• Starting a Business with a Loan: Imagine you start your business with a loan of $30,000 and an initial investment of $20,000. Your debt-to-equity ratio would be 1.5. This is common for new businesses, but keep an eye on this ratio as your business grows.
• Growing a Business through Reinvestment: As your business earns profit, you might reinvest it back into the business. If that total of your initial investment plus your reinvestment is $50,000 and you reduce your debt to $10,000, your ratio lowers to 0.2, showing a stronger financial position.
• Managing Debts During a Downturn: If your business hits a rough patch and accumulates $70,000 in debt while your equity is at $50,000, your ratio increases to 1.4. This signals increased financial risk, and you should strategize on reducing debt or increasing equity.
Maintaining a Healthy Debt to Equity Ratio
Maintaining a good balance between your business debts and the money you have invested in your business is essential. Here are some easy-to-follow strategies to help you keep this balance:
1. Think Carefully Before Taking on More Debt:
• Know why you are borrowing: Only borrow money if it is going to help your business grow. For example, getting a loan to buy a new machine that will help you make more products is a good reason.
• Have a plan for paying back: Before you borrow, ensure you know how you will repay the money. Understand how much interest you must pay and when to make payments.
2. Use Your Profits Wisely:
• Put money back into your business: Instead of taking all the profits out for yourself, consider using some to improve your business. This can be things like buying better equipment, budgeting more on marketing, or paying off some of your debts.
• Choose smart investments: When you put money back into your business, focus on things that will make a difference and help your business grow in the long run.
3. Keep an Eye on Your Business Finances:
• Regular check-ups: Make it routine to review your business’s financial records. This habit will help you keep track of your debts and how much money you have invested in your business.
• Watch for changes: Notice if your debt-to-equity ratio is going up or down over time. Determine if you need to change how you are running your business.
• Get help if you need it: If you find financial records confusing, it is okay to ask for help and hire a bookkeeper or accountant. They can give you good advice and help you understand your finances better.
By following these simple tips, you can keep your business’s debt-to-equity ratio healthy, which will set your business up for steady growth and success.
Key Takeaways
As an entrepreneur or small business owner, understanding the debt-to-equity ratio as an important financial tool can guide you toward smarter, more strategic decisions. A high ratio might signal too much reliance on debt, posing risks in challenging times. Conversely, a low ratio shows a strong equity base but could mean missed opportunities for growth through leveraging debt.
Calculating this ratio is straightforward, and keeping an eye on it helps in strategic decision-making. It is ok to ask for help when you need it. Keep this ratio in mind as you make financial decisions, and you will be better equipped to steer your business towards growth and profitability.
How FINSYNC Can Help
There are 3 primary ways FINSYNC helps business owners. (1) CO.STARTERS courses through FINSYNC can help turn your business idea or side hustle into a thriving business. (2) On our website, you can also apply for a business bank account. (3) In addition, the FINSYNC software allows you to run your business on One Platform – invoice customers, pay bills, process payroll, automate accounting, and manage cash flow. To learn more about how we can help your business start, scale, and succeed, contact us today.