Debt to equity ratios for healthy businesses

Taking on too much debt can make you less flexible and expose you to risk if revenues fall or interest rates rise.

Exactly what level of debt is suitable for your business depends on your precise requirements at any one time.

There is a healthy level of debt, or 'gearing', that enables a business to grow and capture market share.

It's not an exact science, however, and what's regarded as healthy will also differ from industry to industry.

For example, capital-intensive industries such as manufacturing commonly have higher levels of debt than, say, a tech company that operates online.

The debt ratio is a simple formula to show how capital has been raised to run a business.

It's considered an important financial metric because it indicates (a) how financially stable a company is when facing problems with trading or other operational considerations and (b) what ability it has to raise additional capital for growth.

What is the debt to equity ratio?

A company's debt ratio is commonly seen as a measure of its stability.

The ratio measures the level of debt the company takes on to finance its operations, against the level of capital, or equity, that's available.

It's calculated by dividing a business' total liabilities by the total amount of shareholders' equity.

Shareholders' equity represents the company's net worth - that is, the amount shareholders would receive if the company's total assets were liquidated and all of its debts repaid.

It might also be calculated by subtracting the company's total liabilities from its total assets, both of which are itemised on the company's balance sheet.

The resulting figure shows how much the company relies on debt.

A higher ratio suggests that it is more dependent on funding from outside the business, and therefore potentially less stable if it were to encounter problems with trading or other factors relating to how it operates.

Why is the debt ratio important?

Generally, a good debt ratio is around 1 to 1.5.

However, the ideal debt ratio will vary depending on the industry, as some industries use more debt financing than others.

Capital-intensive industries like the financial and manufacturing industries often have higher ratios that can be greater than 2.

A high debt ratio indicates a business using debt to finance its growth.

Companies that invest large amounts of money in assets and operations (capital-intensive companies) often have a higher debt ratio.

For lenders and investors, a high ratio means a riskier investment because the business might not be able to make enough money to repay its debts.

If a debt ratio is lower - closer to zero - this often means the business hasn't relied on borrowing to finance operations.

Investors can be unwilling to invest in a company with a very low ratio, as it suggests the business isn't realising the potential profit or value it could gain by borrowing and increasing the scale of its operations.

Servicing your debt

When deciding what level of debt is suitable for your business, you should consider whether you'll be able to service that debt in the future.

Determining whether your level of debt is healthy means asking questions like the following:

• Do you operate in an industry that naturally requires a high level of debt to function effectively and keep up with competitors?
• How does the result of your debt ratio analysis compare with companies of a similar set-up in your sector?
• Have you provided a personal guarantee for any of the business' borrowing?
• Is your market likely to decline in the near future?
• Could a rise in interest rates affect your ability to service the debt?

Be aware that providing personal guarantees for business borrowing is common, but it can put you at risk of personal liability should the company get into difficulty.

Dealing with debt

If you're having problems dealing with debt, there may be some measures you can take.

Find out more on our Dealing with debt page.

You might also consider debt consolidation and refinancing as possible ways to reduce your monthly repayments.

Even if you don't have any immediate issues, you should make sure your business has sufficient working capital to cope with tougher trading conditions.