What is the debt-to-equity ratio?

Definition

The debt-to-equity ratio is total debt divided by owner equity. On the books, this is a funding mix on the Balance Sheet, not a ledger account and not a test of this month's loan payment.

A landscape crew uses it when a truck loan sits next to the owner's capital. The question is how much of the shop lenders fund versus owners, not whether Friday's payment clears.

It is a stock of claims at a date. Liabilities are what the crew owes; equity is what is left for owners after those claims.

Stay with debt against equity when you read it. Cash available to cover principal and interest is a different page.

Where it shows up

Balance Sheet: Related to debt against equity.

P&L: Related to interest that the debt produces.

Cash flow: Related to principal and interest that have to be paid.

See also: Liabilities · Equity · Covenant

When you look at your Balance Sheet, add the interest-bearing loans and notes, then divide by equity. Notes payable and long-term liabilities are the usual debt pieces; vendor bills are sometimes left out of a tighter reading.

When the ratio is high, lenders fund more of the assets relative to owners. When it is low, owners have a larger residual claim.

The Income Statement does not print this mix. Interest expense shows the cost of the debt; the ratio itself is a Balance Sheet division.

On the Statement of Cash Flows, drawing a loan and paying it back are financing events. This page stays on the mix of debt and equity at a date, not on those cash movements.

How it works

Start with total debt. Truck loans, equipment notes, and other interest-bearing balances are the usual start.

Divide by owner equity. Equity is assets minus liabilities, including capital the owner put in and leftover profit kept in the shop.

A result of 2.0 means two dollars of debt sit next to every dollar of equity. A result of 0.5 means owners fund more of the shop than lenders do.

Stay with this mix when you read it. A large loan payment this month can still sit next to a modest ratio if equity is large too.

Some lenders write a ceiling into a covenant. Crossing that ceiling can put the loan in default even if the crew is busy.

Do not fold vendor bills into debt unless the formula you were given says to. A tighter bank version often uses only notes and other interest-bearing balances.

Owner draws shrink equity and can raise the ratio without a new loan. A capital contribution does the reverse.

This page stays on debt against equity. Whether operating cash can cover the scheduled payments belongs on another page.

Example

Hillside Landscapes holds a $70,000 truck note and a $10,000 equipment loan. Total debt is $80,000.

The owner has $25,000 of capital in the shop and $15,000 of leftover profit kept in equity. Equity is $40,000.

Divide: $80,000 by $40,000. The reading is 2.0.

That 2.0 is the funding mix, not a payment test. The crew can still make this month's truck payment, or miss it, without the ratio moving until a balance changes.

If the owner puts in another $10,000 of capital, equity becomes $50,000. The ratio falls to 1.6 even though the truck note did not change.

If the crew borrows $20,000 more for a second truck, debt becomes $100,000. Against $40,000 of equity the reading is 2.5.

The crew does not post a line that says this ratio. The books already hold the notes and the equity; you divide.

Common mix-ups

This ratio is not the same as whether cash can cover the loan payment. That coverage reading uses cash and scheduled principal plus interest; this page is a stock of debt against equity.

This ratio is not the same as interest coverage. Interest coverage asks how many times operating earnings cover the interest bill, not how the Balance Sheet is funded.

This ratio is not the same as the size of the truck note alone. A $80,000 note against $200,000 of equity is a different mix than the same note against $40,000 of equity.

Related terms

• Liabilities: Everything the business owes to lenders, vendors, employees, and customers.
• Equity: The owners' residual claim on the business after liabilities are subtracted from assets.
• Long-Term Liabilities: Obligations that come due more than a year out.
• Covenant: A condition in a loan agreement the borrower must keep meeting.
• Balance Sheet: A statement showing what a business owns, what it owes, and what is left for owners at a single point in time.
• Notes Payable: Formal loan balances owed to a bank or other lender.
• Return On Equity: Net income measured against owner equity.
• Interest Coverage Ratio: Operating earnings measured against interest expense.