What’s the Right Debt Ratio for Your Small Business?Debt is sometimes necessary, but learn the difference between good and bad debt and how much is the right amount.
We’re all raised to be wary of debt. But in business, debt is not always bad.
“Since I run a startup, debt is often necessary to expand; it covers employees, rent, as well as additional expenses,” said AJ Saleem, Director of Suprex Learning, a Houston-based private tutoring and test prep company.
Here’s how you can tell the difference between “good” debt and “bad” debt and determine the ideal ratio of debt to equity for your small business.
Good debt vs. bad debt
Good debt grows your business and ultimately pays for itself. As Priyanka Prakash, finance specialist at Fit Small Business, explained, “If you take a $10,000 loan to help you market your small business, and the marketing generates $20,000 in revenue, that loan has paid for itself.”
Daniel Feiman, managing director of management consultant firm Build It Backsrwds, noted good debt has several key characteristics. It’s “debt you choose to take on at reasonable market rates, that you can afford to repay, in normal market circumstances.”
Bad debt doesn’t grow your business or comes at a very interest rate or with high fees.
Understanding the debt ratio
The most common way businesses (and their accountants) talk about debt is by using the debt ratio, which is your business’s total debt divided by its total equity. The higher the ratio, the more your business relies on debt to finance its operations — and the greater the risk banks take on when they lend to you.
“There are several standard formulas for calculating debt-to-equity,” said Feiman. These include long-term debt to equity (long-term debt divided by equity) and the total debt to capitalization ratio (current liabilities and long-term debt divided by the sum of current liabilities, long-term debt, minority interest and equity).
The different ratios help inform different kinds of decisions. “If you are trying to calculate who is financing the long-term growth of the firm, the long-term debt to equity is the right ratio. If, on the other hand, you want to review the total amount of obligations a firm has, use the total debt to capitalization ratio,” said Feiman.
Business owners sometimes fall into the trap of focusing only on formal or bank debt. But total debt is broader than that. According to Richard Hayman, CEO of Hayman Consulting Group>, credit from suppliers is a form of debt. So, he said, are unpaid vacations, unpaid taxes, credit card debt and lease obligations. You need to consider it all.
How much debt is right for your business?
What is the right debt ratio? There’s no single answer that fits all businesses.
It depends on several factors,” said Feiman, “including whether you are aggressive or conservative or in a growth or a maintain mode.” The right amount is enough to finance your growth but not so much that you can’t comfortably repay the debt from your projected profits and cash flow.
To begin to understand what ratio may be right for your business, Feiman suggests making peer comparisons. “Look for sources like he Risk Management Association,“>Moody’s and your trade association to give you an idea how much leverage is common in your industry.”
It may also help to think in terms of matching the debt to the need. Hayman said, “In working with many owners, I have found them using short term lines of credit for longer term purposes such as equipment or vehicle purchases.” And that’s bad. He said that by properly matching long term debt with long term investment, a business may be able to handle more debt.