Your Debt Ratios - Do You Have Too Much Debt?
Originally published: 05.01.14 by Ruth King
Increase profitable sales to ensure you can pay your bills
Over the past few months I have written about the liquidity ratios that answer the question: “Can I pay my bills?” Now it’s time to discuss debt ratios — total debt to equity and long term debt to equity.
These ratios measure how much debt your company has from a long-term and an overall perspective. The total debt to equity ratio is calculated by dividing the total liabilities (current and long term) by the total equity. Equity is also called net worth or capital. It usually consists of stockholders’ or owner’s equity, partnership capital accounts, paid in capital, treasury stock and retained earnings.
Current liabilities are bills you owe that must be paid within a year. This includes the current portion of long-term debt, or the principal on loans that must be repaid within a year.
There is no standard for the total debt to equity ratio. It should be greater than zero and as low as possible. I generally see it below three. For companies starting large commercial jobs or just coming out of negative equity situations, however, this ratio can be much higher. The goal is to get it
If the ratio is negative, the company’s net worth is negative and in trouble. The goal is to increase profitable sales to get the company to a positive net worth.
The long-term debt to equity ratio is calculated by dividing long-term liabilities by the total equity. This ratio should always be less than one and greater to or equal to zero for HVAC companies. Some contractors have no long-term debt. Therefore this ratio is zero. If the ratio is greater than one, the company has too much long-term debt and could face problems servicing that debt if revenues decrease. Like the total debt to equity ratio, if the ratio is negative, the net worth of the company is negative.
Like the liquidity ratios, it’s the trends that are important. Trailing long-term debt to equity should be constant, as shown in the Trailing Debt Ratios example. If it’s increasing on a trailing basis, your company has recently purchased vehicles on payments or added other debt payments. Be careful when committing to long-term liabilities. Make sure you have the cash flow to cover those payments, whatever the economic cycle.
The total debt to equity is increasing in the Trailing Debt Ratios example. Since the long-term debt to equity ratio is constant, the debt the company is taking on is short term — it will be paid within a year. Normally you see this when inventory levels increase, or in companies that are growing rapidly. This happens because, as your revenues increase, your accounts payable get higher. You can make the payments for the higher payables because revenues, and collections of those revenues are higher. As the company’s revenues stabilize at the higher sales level, the trailing debt to equity ratio will also stabilize, as seen in the Trailing Debt Ratios example. n
Ruth King has over 25 years of experience in the hvacr industry and has worked with contractors, distributors, and manufacturers to help grow their companies and become more profitable. She is president of HVAC Channel TV and holds a Class II (unrestricted) contractors license in Georgia. Ruth has written two books: The Ugly Truth About Small Business and The Ugly Truth About Managing People. Contact Ruth at firstname.lastname@example.org or 770.729.0258.
Articles by Ruth King
Understand Your P&L Statement: Gross Margin
Understand Your P&L Statement: Cost of Goods Sold
However you decide to categorize expenses in your P&L, it's important to be consistent.
Understand Your P&L Statement: Sales vs. Revenue
Sales are critical to survival — when revenue is actually generated is even more critical.
The 20 Percent Profit Myth
For a realistic goal, include owners’ compensation in the net profit equation.
Rethink Your Bonus Strategy
Enact a profit sharing program, rather than a bonus entitlement.