Updated: 26th January 2020
Understanding Healthy Debt-to-Equity Ratios
Debt is commonly associated with poor financial health and the need to borrow in order to survive, but in business this isn’t necessarily the case. When aligned with a strategic plan, debt enables sustainable growth and development, and plays a key part in a business’ success.
But how do you establish whether the level of debt your business has taken on is healthy? It’s partly about using debt ratios, but you also need to consider other factors and issues relative to your industry.
What is a healthy level of business debt?
When deciding what is a healthy level of debt for a business, consideration needs to be given to the industry in which it operates. Also, growth strategies vary according to different business models within an industry, and where a high level of debt may be an obvious requirement for one business, it could be damaging for another.
Debt ratios play a crucial part in determining whether or not a business has taken on a healthy level of debt - they offer insight into the company’s stability, and serve as a warning for businesses to act if a ratio is unfavourable.
A company may have a detailed plan for expansion that involves taking on significant debt, for example, with the associated risks being acceptable to everyone involved in the business when viewed in context. Perhaps historically low interest rates have encouraged rapid expansion, for instance, or maybe the company has huge potential in the long-term.
Debt ratios to inform business borrowing
A debt-to-equity ratio indicates the level to which a business relies on external funding, in comparison with equity. So what is regarded as a beneficial debt-to-equity ratio, and how do you establish if the result might be unhealthy for the business?
Lenders typically view a debt ratio of 1% or less as healthy but other issues also need to be factored in, such as the business model used, the industry, previous sales and profitability levels, and other factors pertinent to the individual business.
A ‘good’ debt ratio provides an indication that the company is in a strong position, and could continue unhindered by its debt should it suffer a detrimental event such as a market decline.