KYN: Debt Ratio

You have probably been told that knowing your numbers is critical to your business management success. Truer words are rarely spoken. However, it is not lost on me that there are A LOT of numbers at play, and numerous measurements you can take…it is easy to become overwhelmed! The question then begs, “Which numbers are the important ones to know?”

If you are in business, you have heard about KYC: Know Your Customer. Well this is “KYN: Know Your Numbers™” and we begin with the Debt Ratio.

The Debt Ratio (also known as Debt to Asset Ratio) is a leverage ratio, meaning it is a measurement of the debt your business holds. The calculation is “Total Liabilities divided by Total Assets” and the result of the calculation tells you how much of your assets is financed. For example, if you have $5million in total liabilities and $10million in assets, your Debt Ratio is 0.5 : 1 (or just 0.5 for simplicity.)

Each industry has a “comfort zone” for where a debt ratio should be. This comfort zone is also flexible (to an extent) depending on where you are in your business’ life cycle. Knowing what the comfort zone is for the industry in which you operate is important.

Why I am Cautious About the Debt Ratio

1. Because it lends itself to subjective information. Here is what I mean: when buying something, we want the price to be lower; when selling something, we want the price to be higher. While compiling the value of all your assets (a “selling” mindset) it is easy to value what you have at a premium, because A) it is yours, B) you love it, and C) you want to show that it was a good decision to acquire it.
   If the value of business assets is “padded,” then the calculation presents a skewed result to the positive.
2. Off Balance Sheet Items. Over my 15 years as a lender and business adviser, I couldn’t even count the number of “off balance sheet items” I have had to discover. Whether it be trade credit from a vendor (which would lower the total liabilities), leases and leased equipment (which lowers both the total assets and total liabilities), or “forgotten” accounts payable (which, again, lowers total liabilities), the figures that somehow do not get included in the calculation can lead to a profoundly different result
   If the value of the liabilities is incomplete, then the calculation presents a skewed result to the positive.
3. Appreciation of asset values “support” increasing levels of debt. Assets that have experienced an appreciation in value (such as real estate or quota) will lower the Debt Ratio with all other things being equal. This can provide an false sense of security to then take on more debt because “the debt ratio is strong and improving.” This is especially dangerous when the new debt is short term/operating debt. Should the value of those assets decline, there will quickly be pressure put onto the business by creditors.

These examples are not to suggest that there is malicious intent when providing information to do this ratio, but merely to draw attention to a subconscious behavior that is affected by emotion.

Plan for Prosperity

Knowing your numbers is critical, but only looking at current numbers may not tell you enough. What has been the trend of your debt levels, your assets values, and subsequently your debt to asset ratio? What has led to the changes in your asset values? Was it asset appreciation? Do your assets now include far more depreciating assets than before? What has led to the change in your liabilities? Was it debt paydown, or new long term debt? Was it additional short term debt/operating debt? Are your current liabilities making up a greater portion of your total liabilities than 5 years ago (or 10 years ago?)

In the next KYN commentary, we will discuss the trend of short term liabilities & long term liabilities, and how it affects Debt Structure.