How much debt is too much debt when you own a business?
Calculating your debt-to-capital ratio is a quick way to see whether your business is in a stable position. Knowing how to calculate and interpret your ratio will help you keep your long-term strategy on track — and put you in a better position to raise money.
What Is the Debt-to-Capital Ratio?
This ratio measures how a business raises money through debt versus through investors (also called shareholder equity). Businesses that raise a higher proportion of their capital through debt could be at a higher financial risk, as they’ll need to pay off that debt and any interest that accrues.
If you raise money by acquiring investors, you’re not tied to recurring repayments like you are with a loan. However, your investors are entitled to a share of your profits, so the downside is that there could be less profit left over for you.
Because there are benefits and drawbacks to each strategy, a business could use both to raise money. The ratio is also known as the debt to total capital ratio because it measures the share of debt versus all capital raised, whether from debt or from investors.
Calculating the Debt-to-Capital Ratio
You can calculate this ratio using the following formula:
Debt-to-Capital Ratio = Total Debt ÷ (Total Debt + Total Shareholder Equity)
Your total debt is every outstanding interest-bearing debt — short- and long-term — that your business holds. This includes credit card debt, outstanding lines of credit, cash flow loans, equipment loans, vehicle loans, mortgages — basically any debt where you owe interest. Your total shareholder equity is the total value of your business that’s owned by your business partners and investors. You can find these figures on the balance sheets of your accounting statements.
If you don’t know how much equity your shareholders have, you can find it by subtracting your liabilities (i.e., everything your business owes, including debts) from your total assets (i.e., everything your business owns). Whatever’s left represents your shareholders’ equity.
Let’s look at an example. Let’s say that John owns a construction firm. His business has the following outstanding debts:
- $500,000 in equipment loans
- $50,000 in credit card debt
- $30,000 outstanding on a line of credit
- A $1 million mortgage on his office
So his total debt is $1.58 million ($500,000 + $50,000 + $30,000 + $1,000,000 = $1,580,000).
John’s total shareholder equity is $2.5 million, from his own contributions into the company as well as money raised from investors.
Using our formula, John’s debt-to-capital ratio, expressed as a percentage, is 39%:
Debt-to-Capital Ratio = $1,580,000 ÷ ($1,580,000 + $2,500,000) = 0.39, or 39%
When the Ratio Matters
Understanding your financial position. Knowing your debt-to-capital ratio can help you better understand the financial health of your small business. If your ratio is too high, it’s a sign that you could be taking on too much debt.
According to HubSpot, a good debt-to-equity ratio sits somewhere between 1 and 1.5, indicating that a company has a pretty even mix of debt and equity. A debt to total capital ratio above 0.6 usually means that a business has significantly more debt than equity.
John’s construction firm had a debt-to-capital ratio of 0.39, so he could borrow more, if he wants or needs to.
Taking out a loan. When you apply for financing, such as a small business loan, your lender could ask to see your financial statements and for any information about outstanding debts, then use this information to calculate how much debt you have versus how much capital you have. They’d do so because the more debt you have, relative to your company equity, the less you’re able to make payments on another loan. If you’re getting ready to apply for a major loan, such as a mortgage or an equipment loan, you might want to pay down some of your short-term debt to improve your ratio.
Raising money from investors. Potential investors could also check your ratio of debt to total capital. They’ll have a different perspective than lenders, though. On the one hand, they’d probably appreciate a smaller ratio, which indicates that you can safely manage your debt. On the other, a ratio that’s too low could be concerning, as it could mean that you aren’t borrowing enough to grow or that your business equity is too diluted from too many investors, which means it would be harder for a new investor to turn a profit. By understanding your ratio, you can adjust your investment pitch as needed, explaining how you could manage the debt payments if your ratio is high or explaining your plans for generating return on investment if it’s low.
Managing Your Debt-to-Capital Ratio
Now that you understand how your ratio works and why it matters, these tips can help you get more out of this financial measurement.
Check your ratio regularly. To avoid problems sneaking up on you, check your ratio at least once a quarter. That way, you can catch a spike in your debt level. If you’re actively trying to improve your ratio to raise financing, you might want to recalculate more often — once a month or more — to track your progress.
Put the numbers in context. Industries such as construction and manufacturing might carry higher ratios due to the capital-intensive nature of the business. Monitor industry averages through a site such as CSIMarket to see how much debt versus how much equity similar companies are carrying. A higher industry average means you could borrow more than other types of businesses.
Plan for improvement. The main option for improving your ratio of debt to total capital is to pay off your business debts. (Technically, you could also reduce your ratio by bringing on more investors, but only do so if you have a clear need for more investment capital.) Though paying off any debt would help, you might see more benefits by paying high-interest short-term debts first. Not only would you improve your ratio, but you’d free up cash flow. To improve his construction firm’s ratio, John should prioritize paying off the credit card debt and the line of credit first.
Consider how others will view it. Investors and lenders will have different perspectives on your ratio. Lenders might want to see it as low as possible; investors might prefer a balanced approach. As you discuss financing, keep the other party’s goals in mind.
Appreciate its limitations. Your ratio is just one piece of your entire financial pie. To get more perspective, check out how your business looks through other popular accounting ratios.
