What Is a Debt-to-Equity Ratio?
The debt-to-equity ratio gives the extent to which a company finances its operations with borrowed funds versus the capital owned. This is obtained by dividing the total debt of a firm by the total assets of that company. Suppose a firm has total assets worth $100,000 and has borrowed capital amounting to $25,000. The debt-to-assets ratio of the company will be 0.25. A greater ratio signifies a greater dependency on borrowed capital for running operations. The lower the number is, the more dependent the firm is on its own funds. High and low ratios both have their advantages and disadvantages in different industries and contexts.
Using Debt Wisely
When properly applied, debt can work as an engine that would force the business towards expansion. Using loans over equity financing also makes the entrepreneur hold on the profit from his company due to no need to repay dividends like equity investors want and might dilute power to control. Besides offering financial advantages, such as tax-deductible interest, debt is a cheap source of financing. With the growing availability of traditional and online lending sources, companies can obtain capital to finance asset purchases or business operations to achieve key objectives.
The Dangers of Poor Debt Management
However, a large amount or high-interest debt will overstretch a business. Hefty monthly payments could devour cash flow, which in turn may lead to difficulties in paying bills or investing in growth. Economic downturns, like the one resulting from the COVID-19 pandemic, can further stress these conditions, which would be missed payments, damaged credit, or even bankruptcy. A debt-to-equity ratio that exceeds 0.6 is classified as risky as it denotes over-reliance on borrowed capital. A ratio lower than 0.4 indicates adequate debt management but these can vary across the industry thus sector-specific rules must apply.
Is Low Debt Always Better?
Interestingly, not having debt can also be a disadvantage. Companies that avoid borrowing at all costs may miss opportunities for rapid expansion or become too dependent on equity. An appropriate amount of debt allows companies to seize fleeting opportunities and maintain competitive agility.
One of the most important decisions you might make as an entrepreneur concerns how to finance your business. Good and bad debt ratios make it possible to maintain your company’s financial health by creating growth, and that strategic management of debt in relation to a new startup versus scaling an existing operation, may be the determinant to success or failure.