What level of debt is healthy for a business?

Taking on too much debt can restrict a company’s operational flexibility, leaving it open to financial problems should revenues drop. But there is a ‘healthy’ level of debt, or ‘gearing,’ that allows companies to fulfil their strategic plans and thrive in the long-term.

This can be a fine balance, however, and what is regarded as ‘healthy’ can be different for businesses across various industries. So what level of debt could be regarded as healthy for your business, and how is this determined?

Using debt ratios to establish a healthy level of debt

A company’s debt-to-equity ratio is commonly seen as a measure of its stability. The ratio measures the level of debt taken on by the company in order to finance its operations, against the level of capital, or equity, which is available.

The resulting percentage figure shows how much the company relies on debt, with higher percentages indicating a greater reliance on external funding, and therefore potentially reduced stability in the face of trading or other operational problems.

Good and bad debt ratios

Arriving at a debt ratio is not an exact science, however, and many variables affect the outcome and how it might be viewed by stakeholders and investors. These factors can include the nature of the business itself, the industry in which it operates, and its previous trading history.

Commonly, a debt ratio of one or less indicates stability, and the ability of the company to continue operations relatively unhindered by the risk of default due to excessive debt. That is not to say that any debt ratio exceeding 1% indicates an unhealthy level of debt.

For some companies, taking on a higher level of debt can form part of wider expansion plans. Taking a long-term view for growth may involve additional debt, and the generally low cost of borrowing and the return it provides, may be deemed worthwhile by the management.

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What can affect the stability of companies with debt?

• A downturn in the market, wider global recession, or other external factors could impede trade and increases the likelihood of the company defaulting on its debt repayments
• New legislation, whether related to the industry or general policy such as the introduction of the National Living Wage, or auto-enrolment
• A rise in interest rates, or inflation
• New competitors or innovations in the industry
• Internal factors such as ineffective systems and procedures, or lack of investment in technology

Some industries, including construction and telecommunications, naturally require higher levels of debt to operate effectively day-to-day. This is why when you calculate your debt-to-equity ratio, you’ll need to compare the result with similar companies operating in the same sector for it to be of true value.

Risks of taking on too much debt

If you have provided personal guarantees for any of your company’s borrowing, and the business subsequently declines, you may become liable for the total amount remaining if the company is unable to meet the repayments.

If you would like more information on establishing a healthy level of debt in your business, call one of our experts at Begbies Traynor. We are the UK’s largest professional services consultancy, and will provide the guidance you need to successfully leverage your business.  Call for a free consultation – we work from 100+ offices around the country.