If your small business is struggling, it may be because you’ve taken on too much debt. Debt isn’t always a bad thing. In fact, it’s often used as a way for businesses to create opportunities for themselves. In some cases, the accumulated debt will be too much, and it’s up to you to decide how much debt is too much for your business. Too much debt is an idea that is very hard to define because it’s so subjective. And it’s entirely possible that two different people could look at the same company and have two completely different ideas about whether they’re overleveraged.
Banks and investors don’t have a hard time figuring this out, however. When you apply for a loan or an investment, there’s always some kind of financial analysis that happens. They do this so they can determine how much of a risk they’re taking. They want to know how much capital you have vs. how much debt you’re carrying, and they want to know how well the business can weather its own storm. So how much debt is too much? Short answer: It depends, of course. Long answer: Look at your leverage ratios. Your leverage ratios show you how much debt is okay relative to the assets, equity, and income available to manage it.
Your Leverage Ratios
A leverage ratio compares the total amount of debt a company owes to the total amount of its assets, or the total capital that a company has on hand, or to its equity. It tells you how much of your capital came from borrowing, and it shows you whether you are in a position to pay your bills on time. Your leverage ratios can give you a good idea of how high your risk level is, particularly for a small business. The higher the debt (and thus the leverage ratios), the more risk you’re taking on. The numbers you need for your leverage ratio calculation can be pulled from your balance sheet, income statement, and cash flow statement. A high leverage ratio should alert you that your business may have a lot of obligations that could prove hard to meet. It’s therefore an essential yardstick for financial performance, whether you’re an investor or simply trying to make informed financial decisions. Lenders, analysts and accountants read these ratios too, but the owner gets the most out of them. You’ll be able to answer other tough questions: Will I be able to pay off my debts when they come due? Will my debts overwhelm me? How will changes in the business affect my income? Should I make the change in the first place?
There are three types of leverage in business: financial, operating and combined. Financial leverage looks at how much debt your company uses, or plans to use, to pay for its operations. All assets are financed with either debt or equity, and you need to know how much of your assets come from borrowing. Financial leverage should be very carefully evaluated because a company with high financial leverage has less flexibility to pay debt off from profits or owner’s equity when needed. The next kind of leverage is operating leverage. Operating leverage is concerned with a company’s fixed costs and how many of them it has in comparison with its variable costs. The higher your fixed costs, the higher your operating leverage. Fixed costs are costs that don’t change, like the monthly rent on a store. Variable costs are costs that do change, like the cost of groceries for a restaurant. A combination of the two is called combined leverage, which looks at a company’s financial and operating leverage at the same time. Financial and operating leverage are also related through the income statement. Operating leverage shapes the top half of that statement, and financial leverage shapes the bottom half.
There are five leverage ratios that can help you understand how much debt is too much, and each one sets your debt beside some other figure, or the other way around. The idea is that with the help of your leverage ratios, you can tell at a glance whether you’re overleveraged. The debt-to-assets ratio compares the total amount of your debt to the total amount of your assets. The next one is debt to equity. It’s your total debt divided by your total equity. Debt to capital is very similar. This is your total debt divided by total capital (equity plus debt). Then there’s debt to EBITDA. You take your total debt and divide by your EBITDA, which is your earnings before interest, taxes, depreciation and amortization. Last is assets to equity, which is total assets divided by total equity. In finance, high-leverage just means that a company has a lot of debt compared to its assets, capital, or equity. A company can have a high-debt-to-equity ratio even if it doesn’t have a lot of debt, as long as it doesn’t have much equity, either.
What’s Healthy
There’s no single “right” leverage ratio, and you should treat the figure as a rough guide rather than a hard-and-fast rule. What’s healthy depends on your business, your industry and which ratio you’re computing. The right debt-to-assets ratio is a different number for every business, but as a rule, it should be 0.5 or lower. A 0.5 ratio means half of your financing comes from debt. Anything lower and your debt is a minority of your financing. A ratio around 0.8 is another matter. This means that 80 percent of your financing comes from debt, or 80 percent of your assets were purchased through debt, and it may mean the business has taken on too much. If your business carries a ratio of 0.8, you’ll want to make sure you have the cash flow to handle the debt. Still, a higher ratio can be acceptable in some industries, such as capital-intensive businesses that require significant borrowing for their assets.
Here’s how it works with real numbers. Take a small company first, with $30,000 in assets, $12,000 in debt and $20,000 in equity. Its debt to equity ratio is 0.60, debt to assets is 0.40 and debt to capital is 0.375. Notice that these ratios are less than 1. This means that the business has more assets and equity than debt, and the 0.60 debt to equity figure shows that equity makes up most of the company’s resources.
Now say your business has $100,000 in assets, $35,000 of debt, $50,000 in equity and $5,000 in EBITDA. Debt to assets is 0.35, debt to equity is 0.70, debt to capital is about 0.41 ($35,000 divided by $85,000), debt to EBITDA is 7.0 and assets to equity is 2.0. When you see 0.35 for the debt-to-assets ratio, it means the firm has $0.35 of liabilities for every $1.00 of assets. The debt-to-equity ratio of 0.70 means the business has $0.70 in liabilities for every $1.00 of owner’s equity. Your debt to capital ratio shows you are more financed by equity than debt. The debt-to-assets ratio of 0.35 isn’t necessarily a cause for alarm, since it sits well under the 0.5 guideline. A debt to EBITDA ratio of 7.0 simply means your debt is seven times what the business earned before interest, taxes, depreciation and amortization.
The numbers will look different for your company, so the next step is to find out what’s normal for your business. Research healthy ratios for your industry, then compare these ratios to the industry standard. If you’re out of sync, then you need to investigate the possible reasons and make a plan to get back in line. And if you find yourself staring at your financial statements and wondering about your debt-to-equity ratio, earnings, and inventory levels, it’s never too early to seek some professional financial advice on the situation. An accountant or another professional can help you read your ratios. Focusing on the numbers behind your business is key to building the foundation of a healthy company, one with a sustainable bottom line.
