There are many ways in which your business finances differ from your household budget. In both cases, however, it’s important to understand your ratio of debt to income. This figure is of critical importance when you apply for a new source of credit and is a key factor in ascertaining your cash flow.
In both your business and domestic finances, debt isn’t necessarily a bad word. Indeed, companies need to rely on credit to make capital investments and fuel their growth. The trick is borrowing on more advantageous terms not to sacrifice your profit margins to crippling interest rates. And that’s much easier to do when you have a favourable debt ratio.
Here we’ll look at debt to income ratios, and how to calculate yours.
What is a debt ratio?
Your debt ratio (or debt to income ratio) measures your company’s liability against your revenue and assets. You can express it either as a decimal value or as a percentage. Your debt ratio essentially explains how much of your company’s assets are financed by debt. In essence, it is used to ascertain the extent of your company’s leverage.
The higher the proportion of debts to income, the greater your leverage. Thus, a debt ratio of 1.0 or 100% implies that a company has more debts than assets.
Why is your company’s debt ratio important?
Your company’s leverage and liability go hand in hand – especially in the eyes of potential creditors, investors and board members. The greater a company’s liability, the more of a risk they represent. Companies with higher debt ratios typically have slimmer profit margins and less propensity for growth. They are also more at risk of defaulting on their debts, especially if they are in a sector with volatile cash flows like the service and hospitality industries.
A high debt ratio doesn’t necessarily mean that your company won’t be able to access credit. It may, however, mean that you’re forced to rely on poor quality credit with much higher interest rates. And this can impinge on future margins and impede cash flow.
How to calculate your debt ratio
There’s a fairly simple formula that can be used to ascertain your company’s debt ratio. Simply divide your total liabilities or debts by your total assets. Be sure to account for everything so that you get a clear picture of your company’s overall debt burden and not its current debts.
So, for instance, if a company has a total of £5 million in assets, and £1,250,000 in total debt liabilities, its debt ratio is 25% or .25.
What is a good debt to income ratio for a UK business?
There's a huge variance in debt ratios across different industries and sectors. As such, it’s hard to definitively say what is a good debt-to-income ratio.
For instance, a SaaS company with a stable income, low employee turnover and highly automated processes may see a debt-to-income ratio of 40% as perfectly acceptable. However, a coffee shop or retailer may face average debt ratios of around 60%. This is because they typically have high startup costs, high employee turnovers and erratic profit margins.
Rather than chasing a golden ratio, it’s worth researching industry averages and ascertaining your competitors’ debt ratios to find out how yours measures up against the rest of the industry.
We can help
If you’re interested in finding out more about your debt to income ratio, managing cash flow, or any other aspect of your business finances, then get in touch with our financial experts. Find out how GoCardless can help you with ad hoc payments or recurring payments.