Debt ratio: how to control the risk/reward trade off

Every business leader wrestles with the same question: how much to borrow to invest in and grow the business, while controlling the overall level of debt?

No one wants to miss out on a growth opportunity. But “FOMO” (fear of missing out) can sometimes lead us into some hasty manoeuvres that we regret when the real costs come in. However, we want to ensure that we won’t be overly risk-exposed in the event of an unforeseen development.

Here are the financial indicators that will allow you to assess the debt risk-reward trade off correctly. 

Is your company in a position to take on more debt? To find out, one critical indicator is the debt ratio.

Wondering what is the debt ratio? It is obtained by dividing total liabilities by total assets and indicates the percentage of the total asset amounts (as reported on the balance sheet) that is owed to creditors.

By comparing liabilities to assets, the debt ratio lets you identify the firm’s level of dependence on third parties. Your banker will look closely at this ratio before authorising new loans. A lower debt ratio indicates a less indebted company.

Tip: Beyond this general guideline, there is no hard-and-fast rule on what constitutes a good or bad debt ratio. Some sectors of activity, such as metals, construction, energy and agrifood, normally carry higher levels of debt than others.

The debt ratio formula may look simple, but a number of factors must be considered to explain it. While monitoring the debt ratio is critical to measuring exposure to financial risks, you must put this indicator into context to reflect your company’s specific situation. The ratio must be included in your presentation to win over contacts and potential financial partners.

An innovative firm that is just starting out will unquestionably have a high debt ratio. A few months on, if the business has grown, revenue streams would start to reduce the debt.

Tip: It is important to look beyond the numbers to consider the company’s length of time doing business and its development stage. For example, a higher debt ratio for a company that has overhauled its machinery or vehicle fleet will be viewed more positively than a lower ratio for a company that has not invested because capital expenditures tend to signal anticipated growth.

Accurate numbers combined with a clear presentation detailing the company’s track record are real strengths when establishing a relationship with a new financial partner. Each individual company may have access to various types of financing.

The first, and most conventional, is a loan from a bank. Bank debt is often used to finance long-term investments, such as a purchase of premises or equipment required for the business.

Leasing arrangements and overdrafts may also be used for short-term expenses to optimise cash flow, but these will normally incur higher interest rates than long-term loans, and should not be relied on to cover operating expenses ad infinitum.

There are other sources of business liquidity besides traditional bank loans. Investors, business angels, investment funds looking for unusual opportunities with sound business plans, even “crowd funding,” are ways to attract capital investment.

In such cases, your company does not take on any cash debt. Instead, you hand over shares of your company to your investors, giving up some control of your company in exchange for financial investment to help you reach your goals. But choose your investors carefully: make sure you share similar goals and objectives. If your visions differ, there is a real risk of conflict that could be difficult to resolve. 

Tip: To optimise your financing sources, it may be wise to use a variety of contributions. But be careful: they cannot all be used for the same purposes. Bank loans are a long-term commitment and can be used to purchase premises or develop new activities, while bringing in new investors can be a way to undertake significant transactions, such as taking over a competitor.

Few companies can grow without taking on debt. The important thing is that the investments made possible by this debt support your growth rather than weigh it down. It's all about balance!

For more tips and advice on business financial monitoring, download our ebook: Boost your financial performance analysis.