Debt means different things to different people. Most entrepreneurs and company owners view debt as an exceptionally valuable tool. However, they may struggle with the question of how much debt they should prudently absorb, relative to equity.
That relationship is called the debt-equity ratio. To determine your company’s debt-equity ratio, divide the amount of debt owed by company book value, or assets minus liabilities. A low debt-equity ratio of, for instance, 1, suggests your company is not fully leveraging the lower-cost financing tool of debt. A high debt-to-equity ratio of, say, 10, suggests the company is at risk from shouldering too much debt. Happy mediums between these extremes vary, depending on the type of company and its industry.
Here are a few rules of thumb to help you determine the optimal debt-equity ratio to fund your company’s operations.
· If your company is operating in an unsettled, even volatile business climate, it should aim at a lower debt-equity ratio. That’s because a sudden upheaval in the business environment could jeopardize ability to service debt.
· If your company enjoys the benefit of holding long-term assets not susceptible to unpredictable value fluctuations, it can take on a higher debt-equity ratio. Examples of such assets include buildings and heavy equipment.
· Your industry also can affect optimal ratios. If yours is a technology firm that invests in research, a ratio of 2 or lower is advised. Ratios between 2 and 5 are acceptable for manufacturing and publicly-traded firms. Ratios higher than 6 are usually acceptable for banks and other types of financial companies.
In general, getting debt and equity in optimal balance can help you gain needed loans, because bankers carefully review debt-equity ratios.
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