Why Train a Dragon? The Debt-to-equity Ratio Explained

“Would you like a pet dragon for your business?”

“Are you crazy? It would be too big, out of control and would burn through everything in sight!”

“But what if it was friendly, fully trained, just the right size for your business, and could bring you exactly what your business needs to grow?”

“Well, I suppose that could be useful. Why do you ask?”

When you hear the word ‘debt’, what do you think of? High interest rates? Bankruptcy? Your associations are probably not particularly positive. We regularly hear phrases like saddled with, crippled by or even strangled by debt, and, for people in the UK, it’s a common ambition to become ‘debt free’ by the time they retire.

But if you are a business owner, this negative perception of debt could be holding you back. Debt can be a powerful tool for your business, fuelling growth and enabling financial agility. Of course, like an adorable yet potentially dangerous pet dragon, debt needs to be handled with caution.

Here we explore how debt can be used as a funding tool to grow your business, as well as the concept of the ‘optimum debt to equity ratio’.

How does a business fund growth?

Almost all businesses reach a point when they need to spend money in order to grow, whether they are recruiting more staff, moving to bigger premises, investing in new machinery, or upgrading their technology. With greater resource and more efficient working practices, the business can increase its revenue and profits. Those profits can then be put towards further investment, leading to again higher revenue and profits.

Businesses have two main options when deciding how to fund that growth, and both routes have their own benefits and risks to consider.

  1. Take money out of the business’ equity.

A business might choose to use their equity to invest in growth. While this can be the simplest solution, especially for cash-rich businesses, this tactic is not without risk. By reinvesting equity into the business, they are locking their cash up and (if you’ll forgive the cliché) placing all their financial eggs in one basket. If the business runs into financial difficulty, or they have unexpected costs to meet, without cash reserves, they might be facing a problem.

2. Borrow money from a bank or other lender.

A business might choose to borrow the funding they need from a bank or lender, and repay it over time. This enables a business to keep hold if its cash and spread the cost of a project over time via fixed payments. Of course, this method typically involves paying interest on the amount borrowed, and businesses need to be sure that they will be able to meet all their repayments comfortably.

However, while there are pros and cons to both funding routes, many business owners believe that option 1, taking cash from the business and avoiding debt is the ‘safest’ way to grow. There is also a perception amongst some SME owners that a business that has debts is not doing well, and they need to clear their debt as soon as possible to be deemed successful.

In reality, debt is an essential funding tool for growing businesses, and when their debt-to-equity ratio hits the right spot, businesses can accelerate their growth without taking on too much risk.

The debt-to-equity ratio

Investors, banks, lenders, and other financial institutions expect – and in many cases – want a growing business to have some debt.

Every business has a debt-to-equity ratio. In simple terms, it compares the level of debt to how much equity is in the business. It is one of many financial ratios (known as leverage ratios) and metrics that can be used by banks, investors, and lenders to assess a business’ financial health.

To discover your business’ debt-to-equity ratio, there is a straightforward calculation using two figures found on your balance sheet. Take your business’ total liabilities (what you owe to others) and divide it by your equity (your assets minus liabilities).

Here are some basic examples to represent how debt-to-equity ratios are calculated.

 Total liabilitiesTotal equityDebt-to-equity ratio
Company A£10,000£20,0000.5
Company B£10,000£15,0000.66
Company C£10,000£10,0001
Company D£10,000£5,0002

Why is the debt-to-equity ratio important?

Banks and lenders will usually look at your business’ debt-to-equity ratio when deciding whether or not to lend you money, and someone considering investing in your company would want to assess it before making their decision.  To a bank or investor looking in from the outside to assess a business’ financial situation, a low debt-to-equity ratio can mean slow growth and, possibly, that the owners are not investing wisely enough. If a business has a high debt-to-equity ratio, they may owe too much money to debtors and could be in financial distress.

But, outside of those scenarios, is the debt-to-equity ratio worth thinking about?

It is useful for SME not only to have an understanding of this metric (as well as accounts payable, cash flow, accounts receivable, and inventory) to keep a handle on their capital structure and to help them make informed decisions about whether to take on debt.

“Economists have a concept of an optimum capital structure, i.e., the mix of debt and equity funding which maximises growth opportunities without increasing financial risk inordinately. An all equity financing structure will slow growth while an all debt structure would be too risky.

Phillip Bennett, CEO of Bluestone Leasing

What is a healthy debt-to-equity ratio?

The simple answer to this question is, it depends. Optimum debt-to-equity ratios tend to vary greatly depending on the sector, and what the business is trying to achieve.

For example, businesses operating in the financial industry like banks and other financial institutions borrow money in order to lend it, and transportation, energy, telecommunications, and utilities often have large capital investments upfront, so their debt-to-equity ratios will naturally work out higher (typically between 10-20).

Technology-based businesses tend to have a ratio of 2 or below, while large manufacturing and stable publicly traded companies have ratios between 2-5.

In addition to considering the average debt-to-equity ratio for your sector, it is important to remember that the debt-to-equity ratio does not tell a business’ entire story, and there are many exceptions to the rule. A business might take on a lot of debt in a particular year, but if the borrowing enables them to fund expansion that significantly increases profits and cash flow is healthy, the debt will be repaid quickly and the company will grow.

The optimum debt-to-equity ratio will vary sector to sector and business to business etc., but a reasonable bench mark is a ratio of up to 2 parts debt to 1 part equity. I doubt many SME businesses approach anywhere near these levels.”   

Phillip Bennet, CEO of Bluestone Leasing

Businesses that try to keep their debt-to-equity ratio to a minimum for no other reason than they believe ‘debt is bad’ might be shooting themselves in the foot. If a business can only invest in growth when it has enough cash in the bank to buy the assets or invest in a project (while also covering day to day overheads and keeping a precautionary balance in place in case of emergencies) it follows that the business’ growth is going to be somewhat restricted.

So, debt isn’t always bad for business?

It is common for SMEs to try to stay away from debt. After all, who wants the risks involved with inviting a huge uncontrollable dragon into their business? It’s an understandable fear, especially when personal debt carries such negative connotations.

But just think about what you could achieve if you had a perfectly sized dragon working for you. Burning through inefficiency, hunting for the assets you need to grow, intimidating competitors, and strengthening your defences.

The right dragon, or the right level of debt, can be a sure sign of a growing and well-managed business.

Would you like to learn more about using debt as a funding tool via a bespoke finance solution? Click here to get in touch.

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