Debt is a complicated subject for businesses and individuals alike. It does, of course, carry plenty of negative connotations, with concerns about insolvency and bankruptcy inevitably creeping into any discussion about debt.
But the truth is that credit serves a purpose. As much as every business would like to run a balance book in the black at all times, spending only what they have earned in revenue, the realities of cash flow don’t always work like that.
Especially when you are talking about capital investment in your company, whether it’s to buy new equipment or fund expansion plans, or big one-off costs like purchasing new stock, sometimes necessity dictates you have to take out a loan or ask for a finance deal to cover upfront costs.
There is nothing wrong with carrying debts if ultimately it serves the long-term purpose of making your business more successful. But the caveat is, you have to be able to keep on top of the repayments. Extending debt to a level where you are struggling to pay it off spells bad news. In fact, a high proportion of insolvencies are caused by firms overstretching themselves with too much debt and then finding themselves unable to service it.
So what exactly is a ‘safe’ level of debt for your business?
The debt ratio
A company’s level of debt is measured by a figure called the debt ratio. It’s a very straightforward calculation – total liabilities owed divided by total equity.
Debt ratios are one of a number of metrics used to evaluate a business’s financial health. Clearly, a company with liabilities many times greater than the total value of all its assets is not in a very stable or secure financial position at all. All it would take is one of those debts to be called in, say because a temporary cash flow blip meant they got behind on repayments, and they would find themselves in a very precarious situation indeed.
In a perfect world, you’d say that a healthy debt ratio would be less than one – i.e. the total value of your liabilities is less than the value of all your assets. If you can keep debt to that level, then you have nothing to fear from it.
Lots of things can affect your ability to pay off debts, from declining revenues to rising interest rates. The biggest risk for any business owner or director is if the terms of credit make them personally liable for business debts should they fall into arrears. In this situation, it definitely makes sense to keep a debt ratio below one, as it means there is always enough in the business to pay off debts before your own assets come into the equation.
However, for many businesses, keeping debt at such a low level is simply not realistic. In sectors with high equipment and infrastructure costs like manufacturing, telecoms and aviation, for example, borrowing to fund capital investment is seen as critical to growth strategies. It’s not unusual for debt ratios in these sectors to exceed 2 to 1.
These are extreme examples and usually involve large companies with significant investor backing. Still, whatever the size of your company and whatever industry you are in, if your ambition is to borrow to invest in growth, there is nothing wrong with taking on a debt ratio above one.
As long as you have a sound business plan and a clear pathway to growing your business to be able to clear your debts and still be profitable, most analysts would agree that a debt ratio of between 1 and 1.5 to 1 is perfectly manageable. Unless you are in a particularly capital intensive sector, you should think carefully about going any higher, not least because it can send a signal to would-be creditors that you are overburdened by debt and not in the best financial health.
For an in-depth analysis of your company’s exposure to debt, get in touch with our team of specialists today.