As feared as the word “debt” may be in the realm of personal finances, it isn’t necessarily a burden for your business.

In fact, it may open the door to potential opportunities—it all depends on how wisely you manage your debt ratio.

The judicious application of debt can advance your organization’s success, but managing these funds poorly can also limit your cash flow, among other restraints. The distinction lies in how you balance your debt ratio. With careful maneuvering and a healthy debt policy in place, you may achieve lucrative growth potential and greater organizational success.

A precarious balance

In short, an organization’s debt ratio compares its total credit to its cash flow. To calculate yours, simply divide your total liabilities by your total assets. For example, if your business owes $50,000 in liabilities and holds $100,000 in assets, it would possess a debt ratio of 0.5.

A lower figure will denote a larger quantity of cash, whereas a higher one will indicate a greater amount of debt. If it is less than 1, then your assets exceed your debt and your organization is thus funded by equity. If your debt ratio is greater than 1, you have more debt than assets, which, as Investopedia warns, puts you “at risk of default on [your] loans if interest rates suddenly rise.” You may also struggle to make repayments if your revenue declines.

To monitor your organization’s financial standing, make routine assessments of its debt ratio. Identifying this figure monthly or quarterly as well as at the end or beginning of the year can help you track your fiscal health and strategize how to apply your cash flow to address your debts, thereby improving your ratio.

Further, it’s prudent to measure this figure before taking on new forms of credit, such as when purchasing property or investing in new machinery. Lenders and investors typically review an organization’s finances before offering it additional funding and will naturally seek to support those with greater proportions of assets to debt.

What’s a good debt ratio?

Unfortunately, there is no precise answer to this question since an organization’s sector and size will affect its debt tolerance. For example, a medical professional opening their own practice may need to take out significant loans to purchase office equipment, safety and sanitation supplies, medical technology, and more. Meanwhile, an insurance agent may only need a laptop and a good marketing budget. The medical-office owner will likely carry a significantly higher debt ratio, especially in early years, but they may also have a more consistent revenue stream than the agent, empowering them to withstand and pay down greater debts.

Many other factors can affect what an organization can consider a “good” degree of debt. These may include interest rates, the age of the business, and the industry’s steadfastness against economic variations (e.g., a hospitality business may have fewer assets in the offseason).

That said, Investopedia reports that many lenders consider debt ratios between 0.3 and 0.6 to be ideal. Note that while this range is low, it also reflects a bit of debt. This is because some investors actually prefer when organizations carry a certain degree of liability. A very low or zero debt ratio indicates that a business has not yet turned to borrowing to fund its operations, and lenders may be hesitant to be the one to guide its initial forays into the strategy. They may even view its leaders as risk averse and stifling their own growth potential. As with personal finances, gaining some credit experience will make your business appear more trustworthy and, thus, more appealing.

Weighing debt reduction against accumulation

Paying down lines of credit offers numerous benefits beyond mitigating the generally unpleasant feeling of swimming in debt. For one, you can put a stop to the recurring principal and interest payments on these liabilities, improving your cash flow and financial flexibility. Additionally, alleviating debt can boost your credit score and grant you further avenues for investing in your business’s development.

Still, organizations should be comfortable with taking on some lines of credit. This is true even for those who may have fewer reasonable motivations to incur debt. For instance, an insurance agent could calculate a healthy borrowing amount for investing in growth opportunities, such as employing personnel or expanding their service areas. By doing so, they could effectively raise their debt ratio from zero to a more commendable figure like 0.4, in turn opening up their potential for growth opportunities in the future.

To calculate an appropriate amount of debt for you to acquire, reverse the formula outlined previously: multiply your total assets by your target ratio. From there, consider how you could invest this quantity of funds to bolster your organization’s success.

Overall, business owners and entrepreneurs shouldn’t shy away from debt but rather see it as a tool they can use to produce greater assets. As it is said, nothing ventured, nothing gained—and without a healthy debt policy in place, you could be limiting your possibilities.

TAKE ACTION:
Calculate your organization’s debt ratio. Depending on your score, weigh strategies to either pay off your liabilities or strategically invest them in growth opportunities.