Debt, Equity and Efficency Ratios

Debt to equity ratio

Debt ratios measure the ability of the business to repay long term debt.

The debt to equity ratio shows the proportion of capital invested by the business owners to the funds provided by external lenders. It gives a comparison of how much of the business was financed by owner's equity and how much was financed through debt or liabilities.

The formula used to calculate the debt to equity ratio is:

Debt to equity ratio = Total Liabilities ÷ Owners' Equity

The higher the ratio, the more the business relies on debt to finance its operations and the greater the risk to external lenders. A debt equity ratio of 1:1 indicates that the external lenders and the owners are bearing the same degree of risk.

A ratio of less than 1:1 means that:

  • debt is less than owners' equity
  • the business is positively geared
  • the external lenders are bearing less risk than the owners
  • the owner has a stronger financial interest in the business than external lenders

A ratio of more than 1:1 means that:

  • debt is higher than owners' equity
  • the business is negatively geared
  • the external lenders are bearing more risk than the owners
  • external lenders have a stronger financial interest in the business than the owner

Generally, a debt to equity ratio in the range of 1:1 to 4:1 is acceptable but will depend on individual business and industry circumstances. However, most banks will have guidelines and limits for the debt to equity ratio. A ratio of 2:1 is often used for small business loans (a limit of up to $2 loaned for every $1 of owner's equity).

Too much debt can put your business at risk and indicates possible difficulty in meeting interest and principal repayments.

Too little debt means you may not be taking advantage of opportunities and realising the full growth potential of your business.

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