If you have listened to reports from the Bank of England recently, you would think that we are on the verge of an economic collapse. They have made some ominous statements about the level of debt the country has taken on. Does this mean that businesses should be concerned? To an extent, they should. However, a lot of these fears are overblown and discouraging business owners from taking on debt to expand their companies.
There are a lot of financial ratios that you need to look at when running a business. Your debt-to-income ratio is an important factor that many businesses don’t understand or pay attention to.
Your debt-to-income ratio is simply your debt divided by your annual income. A high debt-to-income ratio can have disastrous implications for your business. On the other hand, if it is very low, then it may mean that you aren’t leveraging your business well and aren’t going to scale growth.
Here are some things every UK business owner must keep in mind while looking at their debt-to-income ratio. You can always talk to an outsourced bookkeeping service if you need help.
A “High” Debt-to-Income Ratio is Subjective
If you have been reading The Guardian, Telegraph or other news sites recently, you would think that high debt-to-income ratios were going to cause the entire economy to collapse. The Bank of England stated that UK household debt to national income is 160%.
As a business owner, you may have read these statistics and believed that you need to start reducing your outstanding debt. This is the wrong way of looking at it, because your business is not a household. Your debt is key to the growth of your business. Therefore, a modest debt-to-income ratio is not a problem.
So what is a reasonable ratio? There are a few things that need to be considered.
Some industries require a lot more debt to get started than others. Lenders and shareholders understand this, so they won’t hold a high debt-to-income ratio against you if you actually have less debt than the average competitor.
Debt-to-income ratios tend to be higher for companies that require a large infrastructure, such as utilities and manufacturing facilities. According to CSI Market, the average debt-to-income ratio for companies in the energy sector is 50%, while it is over 100% for companies in the services industry. The debt-to-income ratio for Facebook is lower, since they have a smaller infrastructure and there are many ways Facebook earns money.
Income Growth Trends
While it is important to look at your debt-to-income ratio, you don’t want to obsess over it. You don’t want to be shy about taking on new debt that could help you scale your business. Some companies have been reluctant to take on debt to finance new investments simply because they fear that debt looks bad on their balance sheet.
Keep in mind that there are two sides to the equation. Yes, taking on debt increases your debt-to-income ratio, but only if your income remains constant. If you use your debt to finance new capital that yields a strong ROI, then it could actually reduce your debt-to-income ratio.
So is it worth taking on new debt to finance an investment? If you are using it to finance capital that will significantly boost your net profit, then the answer is yes. You will need to make this estimate by considering both new costs and revenue sources associated with the new investment.
In other words, the amount of debt you take on isn’t the issue. The only problem is when you take on debt to finance a new project that doesn’t pay for itself.
Pay Close Attention to Your Debt – But Don’t Let it Terrify You
Taking on debt is serious business, but it is also a great way to expand a growing business. Don’t obsess over your debt-to-income ratio if your income is growing steadily.