What Is a Good Debt-to-Equity Ratio?
A good Debt-to-Equity Ratio is ≤1.5. Here, your business is safe enough to operate without worries. When the Debt-to-Equity Ratio goes beyond 2, this becomes worrying. It is not safe to operate when such a high Debt-to-Equity Ratio. In most real-world scenarios, What is a Good Debt-to-Equity Ratio depends on the industry of your business/company.
You could be operating in an industry where sales are assured. To your business, maintaining a high debt-to-equity ratio is never a problem. Certainly, your business makes enough to meet all due financial obligations.
Why Should Debt-to-Equity Ratio be Low?
1. It attracts more investors
Investors want to invest in your business if you convince them their money is safe. They quantify the risk involved for their committed money using the debt-to-equity ratio. If your business’s Debt-to-Equity ratio is low, investors are convinced to trust your business with their money.
Investors put their money in businesses with low Debt-to-Equity ratio because of the funding model of your company’s growth. If you have a low Debt-to-Equity ratio, your business relies less on debts to fund its operations.
The opposite explains why investors might avoid funding your business because of its high Debt-to-Equity ratio. When the ratio is high, it signals to investors that your business heavily relies on debts to fund your company’s operations. Growth that relies heavily on debts is not sustainable and might take a long time to start reaping profits. Investors look for other investment opportunities with a faster probability of income on the sum invested.
2. Increases chances of getting business loans
Lenders interpret the Debt-to-Equity ratio differently from how investors might look at it. Lenders are projecting to fund your company and earn interest on the principal amount you receive. To them, this interest is the profit.
Lenders assume your company is better off to pay debts if you have a lower Debt-to-Equity ratio. It signifies to them you are not overloaded by obligations that could overwhelm your business to settle. With a business that has a low Debt-to-Equity ratio, you can enjoy better rates from lenders.
Since your business might end up looking for that extra financial boost, keep your Debt-to-Equity ratio as low as possible. The assurance that your business can get instant financing gives you the confidence to grow in unchartered waters.
3. Enables a company to pay off debts even if income changes
Your business pays creditors from the revenue it makes. This explains why businesses try to maximize their sales volume. With high revenue, profits are also considerably high even after paying off your creditors. There is enough left for your venture to plow back after settling short-term and long-term liabilities.
In times of economic struggles, the income of your company could decline. In such a decline, it can be hard to pay creditors because the revenue has been lost. However, with a low Debt-to-Equity ratio, your liabilities are lower. Your business can use some of its equity and pay off due liabilities.
A low Debt-to-Equity ratio saves your company from losing assets in quest to settle liabilities. No fixed asset needs to be sold to meet the financial obligation of a due long-term liability. Your company is thus well armed with its tool to trade even when economic forces have resulted in revenue decline.
4. It leaves you with enough income to reinvest
Revenue is majorly used to pay off long-term liabilities that have fallen due. The higher the amount of long-term liability, the higher the amount you take from revenue to meet such financial obligations. When the Debt-to-Equity ratio is low, you don’t spend most of your revenue to meet liabilities. Instead, a sizable sum of your business’s revenue is reinvested back.
Business growth is possible using both debts and reinvested revenue. This builds more value for shareholders’ equity and your business at large. With consistent business growth, you can tap into more markets and increase the market share of your business.