If you’re a small business owner, it’s likely your business is operating on a balance between its available capital or equity, and its total debt. The difference between the two is known as the business’ ‘debt ratio’ or debt-to-equity ratio. This debt ratio is often used by investors as an indicator of business health and whether or not a company’s stock is worth investing in. The debt ratio is typically calculated using the total debt (including short and long term liabilities) on the company balance sheet but sometimes the definition of debt includes only long-term debt. So what, exactly, is a ‘good’ business debt ratio?
Calculating Your Business Debt Ratio
Determining your business’ current debt ratio should be fairly straightforward using your company balance sheet – simply take the total amount your business uses in order to finance its operations and then divide that by the business’ available capital. For example, if you have total debt of £10 million and £30 million in assets then your available capital will be £40 million. Divide the £10 million of debt by the £40 million of available capital and you reach a debt ratio of 25% or 0.25. The more you have borrowed to operate your business the higher your debt ratio percentage will be. If you have a ratio of higher than 1 you have more total debt than available capital.
A business’ debt ratio is closely related to the concept of leveraging and the ratio could also be described as the leverage or risk of a business. While a company may have enough in available assets to pay for expenses, it may choose to borrow funds instead if it can create leverage. This is done by using the money to create a better rate of return for investors than the cost – usually, the payment in interest – of borrowing that money. While debt used wisely through shrewd borrowing can be a powerful tool for business growth, too much debt on the books means the business is highly dependent upon debt to maintain operations. This, in turn, may indicate an unnecessarily high risk for investors as a change in business fortunes could leave the company unable to service its debt payments.
Determining a good business debt ratio for your company will depend more on industry averages than absolute numbers. Some analysts suggest a good ratio is anything less than 1 as this means the majority of assets are financed through equity rather than debt. However, while higher debt ratios usually indicate more risk for investors, they can also offer greater leverage in some circumstances – for example, when interest payments can be written off as tax deductions. As such, debt ratios higher than 1 do not always mean a business has made bad financial decisions. It simply means they are a company relying more heavily on debt to service their operations.
While it may be difficult to generalise the best business debt ratio for your company, you should always be aware of typical debt ratios among your competitors. If you have a much higher ratio than theirs, you may be exposing your business to higher-than-necessary risk. If this is the case, you should consult a professional to work out ways to lower your debt ratio in the future.
Visit our buisness debt advice pages for more information, or contact us to speak to an expert.