Issue #36

Debt-to-Equity and What Lenders See In It

Corinne Vandermeer had a signed contract in hand when the bank turned her down.

Stonecrest Masonry Supply had been selling brick, block, and stone veneer to contractors around Albuquerque for fourteen years. A regional builder had just committed to buying through her for a 340-home development. She needed $400,000 to stock the yard and add a second delivery truck.

Revenue was up. The company was profitable. She had never missed a payment on anything.

The loan officer said no in eleven minutes and pointed at one number on her balance sheet.

The number in question

Debt-to-equity compares what the business owes to what the owners have actually put in and left in.

Debt-to-equity ratio = Total liabilities ÷ Total shareholders' equity

Both figures come straight off the balance sheet. Equity is what remains after liabilities are subtracted from assets, which is why the ratio really answers a blunt question: of everything this company controls, how much is financed by other people?

Stonecrest's numbers:

$1,240,000 ÷ $620,000 = 2.0

Two dollars of debt for every dollar of Corinne's own stake. Add the $400,000 she was asking for, and the ratio moves to 2.65. The bank's internal policy capped new lending at 2.0 for her industry.

What the bands actually mean

There is no universal good number, and anyone who quotes one without asking your industry is guessing.

Context decides everything. Utilities and telecoms routinely operate above 2.0 because they own regulated infrastructure producing predictable cash. Banks run higher still, since borrowing and lending is the business itself. A software company with no inventory and no equipment might sit at 0.3 and look overcapitalized.

Comparing Stonecrest to a bank tells you nothing. Comparing it to other building materials distributors in the Southwest tells you plenty.

A very low ratio is not automatically a win either. Debt is cheaper than equity, and the interest is deductible. A company sitting at 0.2 while turning away profitable expansion is leaving return on the table, which is why some investors read an unusually conservative balance sheet as a management problem rather than a strength. The useful question is whether the borrowed money earns more than it costs.

A version of the ratio that reads more honestly

Total liabilities lumps together things that behave very differently. Accounts payable due in thirty days sits next to a mortgage due in twelve years, and the two carry nothing like the same risk.

Long-term debt-to-equity = Long-term debt ÷ Total shareholders' equity

Corinne's $1,240,000 broke down into $540,000 of accounts payable and accrued expenses and $700,000 of long-term obligations, including her building mortgage and equipment notes.

$700,000 ÷ $620,000 = 1.13

That figure looked considerably better, and it was the one her CPA used to reopen the conversation. Short-term payables turn over constantly and are backed by inventory the company is already selling. Long-term debt is the commitment that binds you through a slow year.

Both numbers are true. Presenting only the flattering one to a lender who will calculate the other anyway is a bad strategy.

The lease trap that inflates the ratio

Something worth flagging for anyone who leases heavily.

Since ASC 842, right-of-use lease liabilities count as liabilities in this calculation. A company that leases its warehouse and its fleet carries those obligations in the numerator exactly like borrowed money. Two identical distributors, one owning its building and one leasing it, will show different D/E ratios purely because of that structural choice.

Corinne's $1,240,000 included $210,000 of lease liabilities she had never thought of as debt.

Four ways the ratio actually moves

Only two levers exist. Shrink the numerator or grow the denominator.

Retaining profit is the slow, reliable one. Every dollar of net income left in the business increases equity and lowers the ratio without anyone writing a check. Owner draws do the reverse, which is why heavy distributions quietly wreck a balance sheet over a few years.

Paying down long-term debt works on both sides of the fraction at once when funded from earnings.

Injecting owner capital raises equity directly. Corinne had $95,000 in a personal brokerage account.

Selling idle assets to retire debt tightens the ratio and usually improves return on assets at the same time. Stonecrest had a flatbed truck that ran maybe nine days a year.

She ran the combination. Twelve months of retained earnings at roughly $180,000, applying $140,000 of it plus the truck proceeds against her equipment notes, and putting in $95,000 of her own money.

What lenders are really testing

The ratio by itself never gets a loan approved. It gets a file rejected.

A credit analyst reads D/E as a cushion question. If revenue drops 20% next year, does enough owner capital sit underneath the debt to absorb the hit before the bank starts losing money? High leverage means a thin cushion, and a thin cushion means the loan committee needs a reason to say yes.

That reason is usually cash flow coverage. A business at 2.5 with rock-solid debt service coverage can still get funded. A business at 1.2 with erratic collections often will not. Lenders pair the two deliberately, because leverage describes the structure while coverage describes the ability to carry it.

The other thing analysts look for is direction. A ratio that has climbed from 1.1 to 2.0 over three years tells a different story than one that has held steady at 2.0 since 2019. Rising leverage with flat earnings suggests a company funding losses with borrowed money, and that pattern closes doors faster than any single reading.

Check your own ratio before someone else does. Pull the last balance sheet, divide total liabilities by total equity, and find out what a lender sees in the first eleven minutes.

Corinne got her $400,000 the following spring. The contract was still there.