Contents
Managing your finances is one of the most critical aspects of running a successful business in Australia. If you’re like many business owners, you may have asked yourself, “What is a good debt-equity ratio, and why does it matter for my company?” Whether you’re just starting out or looking to scale, understanding your debt-equity ratio can help you make healthier financial decisions and improve your business’s long-term stability.
In this guide, we’ll break down what the debt-equity ratio means, how to calculate it, how to assess whether your business’s debt to equity is “good” or “bad”, and why this financial metric matters – especially for startups and small businesses in Australia. We’ll also outline some best practices for using the debt-equity ratio as a tool in your business planning. If you’re feeling a bit overwhelmed, don’t worry – we’re here to explain the essentials, step by step, so you can focus on building a business that lasts.
What Is the Debt-Equity Ratio?
The debt-equity ratio (sometimes written as debt-to-equity ratio or just D/E ratio) is a simple financial metric that shows how your business is financing its operations: through borrowed money (debt) or through owners’ funds (equity). In other words, it’s a quick way to see how much risk your business is taking on by using loans and credit, relative to what you and your shareholders have put into the company.
When you hear someone talking about the “debt equity ratio meaning”, they’re referring to this relationship. The ratio is often seen as a measure of your company’s financial leverage and risk – if you rely heavily on debt, there’s more pressure to make repayments, even if business slows down.
How Do You Calculate the Debt-Equity Ratio?
Let’s start with the formula. The debt-equity ratio formula is:
Debt-Equity Ratio = Total Debt / Total Equity
- Total Debt: This includes all loans, credit cards, overdrafts, and any other form of borrowings your business is responsible for repaying.
- Total Equity: This represents the funds the owners or shareholders have invested in the business (including retained earnings, if any).
For example, if your business has $200,000 in loans and $100,000 in owner’s equity, your debt-equity ratio would be:
Debt-Equity Ratio = $200,000 / $100,000 = 2.0
This means your business has two dollars of debt for every dollar of equity.
You might also hear terms like equity ratio, which simply focuses on the proportion of equity to total assets, or “what does debt to equity ratio show?” – which is about understanding the story your business’s balance sheet is telling.
Why Does the Debt-Equity Ratio Matter?
The debt-equity ratio is important for a few reasons:
- Financial Health Check: It helps you see at a glance how risky your financial position is. Too much debt can put your business at risk of default during tough times, while too little debt might mean you’re missing out on growth opportunities.
- Access to Finance: Lenders and investors often look at your debt-equity ratio to judge whether you’re a safe bet.
- Business Planning: Knowing your ratio can help you decide if you should borrow more or focus on building up your equity – for example, by reinvesting profits.
- Benchmarking: Comparing your debt-equity ratio with businesses in your industry can help you understand how you’re tracking.
Essentially, the ratio is a signal. A high ratio means you’ve got more debt – which can boost your potential returns, but also your risk. A low ratio means you’re relying more on equity funding, which may be safer but could limit your growth if you can’t access extra cash when you need it.
What Is a Good Debt-Equity Ratio for Australian Businesses?
There’s no one-size-fits-all answer here – the “good” or “bad” range for the debt-equity ratio depends on your type of business, what stage you’re at, and your industry norms. However, there are some general guidelines you can use.
Typical Ranges for the Debt-Equity Ratio
- Low (under 1.0): Your business has more equity than debt. This is generally a safer, more conservative approach, especially for service businesses or those with steady, predictable cash flows.
- Medium (1.0 – 2.0): This is a balanced range. Many Australian businesses – especially those looking to grow – sit here. It’s enough debt for some “gear” or leverage, but not so much to put the business under stress if things get bumpy.
- High (over 2.0): Your business is heavily geared towards debt funding. This can work for high-growth startups or capital-intensive businesses, but it comes with added risk. Lenders will examine your cash flow carefully, and you may face higher interest costs.
In Australia, a debt to equity ratio around 1 – 1.5 is often considered reasonable by banks and investors for small to medium businesses. Very high ratios can make it harder to access more finance or weather a downturn.
Factors to Consider for Your Business
When deciding what’s right for your business:
- Your Industry: Construction, real estate, and manufacturing firms often carry more debt due to high upfront costs. Service-based or tech businesses can usually run with much less debt.
- Growth Stage: Startups and scale-ups sometimes use more debt when they’re expanding rapidly, but the ability to service those loans reliably is crucial.
- Cash Flow: Strong, predictable cash flow means you can handle higher debt levels. But if your revenue fluctuates, a lower debt-equity ratio might be safer.
- Economic Conditions: Uncertain times (like during COVID-19) may call for a more cautious, lower debt ratio.
It’s always a good idea to compare your ratio with similar businesses in your sector, or speak to a business adviser or business valuation expert.
Is a High or Low Debt-Equity Ratio Better?
This comes down to your business goals and risk tolerance.
- High Debt-Equity Ratio: This can fuel faster growth because you’re using borrowed funds to expand. However, it also means you must keep up with repayments, even if sales slow or costs rise. Too much debt can limit your business’s ability to survive tough times or pivot quickly.
- Low Debt-Equity Ratio: This usually means you’re playing it safe, relying more on your own money and less on loans. It may slow your growth, but reduces the risk of insolvency (not being able to pay your bills).
Banks and investors want to see that you’re responsible with your borrowing. They’re often cautious if your business looks over-leveraged (too much debt), as this increases the risk that you can’t meet your obligations.
If you’re unsure, getting external advice is a smart move. An experienced commercial lawyer can help analyse your business structure, contracts, and obligations so you can manage risk while pursuing growth.
What Does the Debt-Equity Ratio Show Lenders and Investors?
Lenders and investors use the debt-equity ratio as a key sign of your financial health and strategic choices. Here’s what they look for:
- Sustainability: If your business can comfortably meet its current and future repayment obligations.
- Management Quality: Whether you’re making prudent financial decisions (not over-borrowing).
- Potential Red Flags: A sudden change or spike in the ratio can indicate financial trouble, such as cash flow issues or unplanned borrowing.
- Ability to Attract Funding: A healthy ratio means you’re more likely to secure additional loans or attract investors.
Remember, a low ratio isn’t always “better.” If you never use financing, you might miss opportunities to expand, upgrade, or innovate. The goal is finding the right balance for your industry, risk profile, and growth plans.
How Can You Improve Your Debt-Equity Ratio?
If you’re concerned your business is carrying too much debt for your equity base – or if your bank wants to see a change – start by reviewing your numbers. Here are some practical steps:
- Increase Equity: Reinvent profits, seek investment from partners, or retain more earnings in the business.
- Reduce Debt: Pay off high-interest loans or restructure existing debts.
- Boost Cash Flow: Improve invoicing systems, cut unnecessary spending, and negotiate better terms with suppliers or customers.
- Review Business Structure: The right structure (such as a company vs sole trader) can impact risk, flexibility, and access to financing. See our guide on ABN vs ACN for more on business structures.
- Plan for the Future: Create a business plan and regularly monitor your key financial ratios.
What Legal Considerations Should Your Business Keep in Mind?
Financial ratios are important, but every Australian business also needs to keep on top of its legal and compliance obligations, especially when using borrowed funds or raising equity.
- Disclosure Requirements: If you’re seeking investment, you may be required to make certain disclosures to investors or regulators. Learn more about prospectus requirements for capital raising.
- Director Duties: If you operate as a company, directors must avoid “insolvent trading” (continuing to incur debts when the business is unable to pay them). See our detailed explanation of insolvent trading risks.
- Loan Agreements: Always put any loan arrangements between shareholders or related parties in writing. This protects all sides and helps clearly define repayment terms. Reviewed and tailored loan agreements should be part of your setup.
- Shareholder & Unitholder Agreements: If you have equity investors (whether family, business partners, or outside investors), get clear agreements in place that set expectations and protect everyone involved.
- Risk Management: Contracts, terms and conditions, and insurance all play a role in managing overall business risk.
It’s wise to talk to a lawyer with commercial expertise for a review of your documents and risk profile before borrowing or raising new equity.
What Legal Documents Will You Need?
Setting yourself up for financial success isn’t just about crunching numbers. Having the right legal documents helps keep your business safe as you balance debt and equity. Consider these essentials:
- Loan Agreement: Sets out the terms (amount, repayment, interest, consequences of default) if your business borrows money, even from family or friends.
- Shareholders Agreement: If you raise equity from investors or co-founders, this agreement governs ownership, voting, decision-making and can help prevent disputes.
- Terms & Conditions: For customers, to limit liability and set out key payment terms.
- Privacy Policy: If you collect any personal information from customers (such as for accounts or marketing), you’re legally required under Australian law to have a Privacy Policy.
- Employment Agreements: If you have staff, make sure written contracts are in place to clarify roles, expectations and protections.
Remember, every business is different. Not every business will need every document, but it’s always safer to get legal guidance on which ones are necessary in your case.
Key Takeaways
- The debt-equity ratio helps you understand your business’s balance of loans versus owner/investor funding, and is a key risk indicator.
- A “good” debt-equity ratio in Australia is commonly around 1 – 1.5, but this varies by industry, growth stage, and risk tolerance.
- Both too high and too low debt-equity ratios have implications; the best ratio for you depends on your business circumstances and future plans.
- Lenders and investors use your ratio to assess your financial stability and ability to grow or weather downturns.
- Improving your ratio is about increasing equity, managing cash flow, paying down debt, and choosing the right business structure.
- Protect your business by having clear contracts and legal documents in place, and seek tailored legal advice where needed.
If you would like a consultation on understanding your business’s debt-equity ratio or business structure, you can reach us at 1800 730 617 or team@sprintlaw.com.au for a free, no-obligations chat.
Meet Our Lawyers for Getting Finance
Get in touch now!
We'll get back to you within 1 business day.
Book in a free consultation with us to discuss your legal needs.