Why This Routine Matters
The Debt-to-Equity (D/E) Ratio reveals how your business is financed: by borrowing (debt) or by owner/investor capital (equity). This is a critical measure of long-term financial risk.
A high D/E means you are relying heavily on lenders and interest payments, making your business fragile during economic downturns.
This routine monitors your financial leverage to ensure you don’t expose yourself to excessive risk.
Monitoring Frequency
Quarterly: Must be performed quarterly.
Annually: Use the quarterly data to set a long-term goal for reducing overall leverage.
Ratio: Debt-to-Equity Ratio (D/E)
This ratio compares what the business owes to creditors versus what the owners have invested.
Step 1: Calculate Your Debt-to-Equity Ratio
A. Find the Inputs
Total Liabilities: All debts and obligations (short-term and long-term). (Found on your Balance Sheet).
Total Equity: The owners’ stake in the business (Owner’s Capital, Retained Earnings). (Found on your Balance Sheet).
B. Calculation
Example: If Total Liabilities are $150,000 and Total Equity is $100,000: D/E Ratio = $150,000 / $100,000 = 1.5
Step 2: Interpretation and Trend Analysis
| Result & Interpretation | Action Trigger | Trend Analysis |
| Ideal Range (GOOD): Below 1.5. You have less debt than equity, indicating financial stability. | Maintain: You have a safe level of leverage and low risk. | Look for a Falling Ratio. This is a Positive Trend—you are successfully paying down debt and increasing equity. |
| High Risk (WARNING): Above 2.0. Your creditors (banks) have a larger stake in the business than you do. | Immediate Action Required: New debt should be avoided, and debt reduction prioritized. | Look for a Rising Ratio. This is a Negative Trend caused by taking on new loans without a proportional increase in retained earnings. |
Step 3: Remedial Actions (Reducing Financial Risk)
If your D/E Ratio is rising or above 1.5, implement these remedial actions:
Aggressive Debt Paydown:
Action: Commit to dedicating a specific percentage of your Net Income (e.g., 50%) each quarter to paying down the principal of your highest-interest debt (a Sprint Task).
Limit New Borrowing:
Action: Put a moratorium on all non-essential business debt (e.g., new equipment financing, line of credit increases).
Boost Equity:
Action: Focus on improving your Net Profit Margin, as Net Income automatically increases Retained Earnings (Equity).
Action: If possible, consider increasing owner investment or seeking new capital investment (equity financing) rather than debt.
Turn this into a Routine
We want to make this a regular Routine for your business in order to ensure your financials stay healthy.
This sort of Routine lends itself to a simple spreadsheet so you can;
- calculate the results for the selected period
- see at a glance if the results are improving or worsening over time
- take any remedial action required and monitor if that works
If you are familiar with spreadsheets, you can automatically insert so-called ‘Traffic lights” by colour coding Bad (red), Watch (yellow) and OK (green) to instantly catch your attention if results change. See our template spreadsheet that does all this
This article was provided by Scott Williams AO FAIDC. It describes the way best practice in many management areas has been brought together in the 12Faces GamePlan System. The Goal is to provide an easy to use and repeatable “flywheel” to improve small business owners’ outcomes. Scott is the Founder of NFP small business support services 12Faces and MentorSME and has a Philanthropic Foundation supporting students in education. Scott’s business Petals Network was National Small Business of the Year and 4 times in the Top 100 Fastest Growing Australian Businesses LinkedIn