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BGF explains: What is a debt-to-equity ratio?

It is important to monitor the financial health of your business if you want to achieve sustained growth and success. One part of this is to examine and understand your debt level, and thus the level of financial risk in the business. But how can a business tell if its debt level is appropriate? Here’s where the debt-to-equity ratio comes in.

What is the debt-to-equity ratio for a business?

The debt-to-equity ratio is one example of a methodology used by businesses to measure how indebted they are – in other words, their financial leverage. In simple terms, it calculates the degree to which the company is financed by debt.

The ratio calculates all your debts and divides them by what the total balance sheet is worth, typically expressed as shareholder equity. An example would be if the total debt of your business was £50 million and the combined equity was £100 million, then your debt-to-equity ratio would be 0.5.

The ratio is a simple yet effective formula for determining the financial health of your business, and the level of financial risk you are carrying. Using it, a business can compare itself against industry standards, or even competitors.

Why does the debt-to-equity ratio matter for a business?

Heavily indebted businesses are usually considered financially unhealthy. Because of the amount it costs to service their debt, these companies may find they cannot afford to invest in expansion. In extreme cases, the cost of servicing their debts causes them to become insolvent.

On the other hand, a low ratio suggests a business has borrowed less than it could. Many financially healthy businesses use borrowing as part of their funding mix, given it is typically a lower cost. To borrow less than one’s peers might put a business at a commercial disadvantage, although with a lower risk balance sheet.

These factors are important if the business is seeking equity investment, for example from a private equity firm or a provider of growth capital. Investors look carefully at measurements such as the debt-to-equity ratio. They may decide not to invest if the ratio is far from where it should be. Equity investment, however, can be useful, as it is typically more flexible than debt, and can be used to decrease the level of financial risk in a balance sheet.

In summary, having an understanding of your debt-to-equity ratio leaves you better equipped to make the right decisions for the health of your business, and the capital that could be available to support growth. Understanding where your debt-to-equity ratio should be in relation to your growth and industry is equally as important.

What is a healthy debt-to-equity ratio?

What counts as a “healthy” ratio varies between industries. It is influenced by many factors such as the company’s cashflow dynamics, its stage of growth, its tangible assets and the terms of existing debt. It is therefore difficult to generalise; however, it is no surprise that most investors and analysts prefer to see a debt-to-equity ratio that is not too high, but also not excessively low.

These analysts will gauge the appropriate range based on comparisons with other companies. For example, high ratios are reasonably common in the financial services sector. On the other hand, capital-intensive businesses that produce goods and services tend to have lower ratios.

For a growing company, a higher debt-to-equity ratio can be a positive sign that the business is investing heavily in expansion – although this needs to eventually convert to cash, in turn bringing down the ratio, to prove investment was worthwhile. Conversely, a lower ratio is a good sign for a mature company as it demonstrates the financial strength and stability that has been achieved.

Equity vs debt with BGF

Borrowing is not the only way to fund expansion. For many businesses, equity funding – for instance, minority capital – is a good way to raise money.

Equity funding can unlock resources to put towards business expansion. Unlike debt, equity funding does not put a financial burden on the company, meaning more of your cashflow is free to reinvest in the business.

BGF is an investor that’s different by design, funding more than 450 businesses since our inception in 2011. We can help you balance your debt-to-equity ratio as a minority investor, allowing you to pursue your own plans for growth. We are the most active investor in the UK and Ireland, delivering more than one investment a week for businesses with big growth ambitions. Our goal is to be a cooperative partner to help your business grow, scale and succeed with our extensive experience and Talent Network.

We could be a perfect fit for your business. Contact our team to discuss how our unique form of funding can help improve your debt-to-equity ratio and set your business up for long-term success.

The information contained in this article is for general information and use. It does not constitute any form of advice and is not intended to be relied upon in making any investment decision. Independent advice should always be sought as to whether a particular transaction is suitable having regard to your personal and financial circumstances.

 

BGF Insights 05.23.2022
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