3 Debt Management Ratios for Your Small Business

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To learn how to calculate the debt-to-asset ratio, the debt-to-equity ratio, and the times-interest-earned ratio for your business, you will need your balance sheet and income statement. These ratios will show you how well your business is doing when it comes to operating and paying down its debt. These debt ratios look at your company's assets, liabilities, and stockholder's equity.

Key Takeaways

  • The debt-to-asset ratio, the debt-to-equity ratio, and the times-interest-earned ratio are three important debt management ratios for your business.
  • They tell you how much of your company's operations are based on debt, rather than equity.
  • It's important to understand how well your business is doing to manage its debt so that you can make smart decisions to keep the company in business for a long time.

Debt-to-Asset Ratio

The debt-to-assets ratio shows you how much of your asset base is financed with debt. The key thing to remember is that if 100% of your asset base is financed with debt, you're bankrupt! You want to keep your debt-to-asset ratio in line with your industry. You also want to watch the historical trends in your business. Your ability to cover your interest expense on debt is also important (more on that later).

Take a look at your balance sheet. All the data you need is here. The debt-to-assets ratio is calculated like this:

Total Debt / Total Assets

Let's say your total assets on your balance sheet for last year were $3,373. In order to get total debt, you have to add together current debt (current liabilities)—let's say it's $543—and long-term debt, which we can say is $531.

The calculation now becomes:

$543 + $531 = Total Debt of $1,074

$1,074 / Total Assets of $3,373 = 31.8%

The debt-to-assets ratio for your business is 31.8%, which means that 31.8% of your assets are purchased with debt. As a result, 68.2% of your assets are financed with equity or investor funds.

If you don't have industry data to compare it with, you can calculate the ratio for the current year. Let's say you do that, and see that the debt to assets ratio for the current year is 27.8%.

From last year to this year, the debt-to-assets ratio for your business dropped from 31.8% to 27.8%.

A drop in the debt-to-assets ratio may be a good thing, but it's important to get more information so you can analyze it adequately.

Debt-to-Equity Ratio

A business is financed by either debt or equity (money invested by owners) or a combination of the two. The debt-to-equity ratio measures how much debt is used to finance the company in relation to the amount of equity used.

Using debt financing is riskier for a company than using equity financing. As the proportion of debt financing goes up, the risk of the business also goes up. That's why calculating this ratio is important, particularly for the owners of the business.

Take a look at your balance sheet. Look at the total debt and shareholder's equity. Those are the two figures that you need to calculate the debt-to-equity ratio.

The debt-to-equity ratio is calculated like is:

Total Debt / Shareholder's Equity

Using the same info from earlier, your business debt is $1,074. Let's say your shareholder's equity is $2,299.

The new equation becomes:

$1,074 / $2,299 = 46.7%

This means that 46.7% of your company's capital structure is debt and the remainder is supplied by investor capital. Like any other ratio, you need comparative data in order to know if this is good or bad. Let's look at the current year's info like we did in the last example above.

You calculate this year's debt-to-equity ratio and the result is 38.5%. That means your business is using less debt to finance its operations now than it did last year, which may be good. You still should do more advanced financial analysis to know that for sure.

Times-Interest-Earned Ratio (Also Known as Interest Coverage)

Another debt or financial leverage ratio that is important to calculate for your company is the times-interest-earned ratio (TIE), also known as the interest coverage ratio.

The TIE ratio tells you how well your business can cover its interest expense on debt.

If your business uses debt financing, it has to be able to pay its interest expense.

Usually, if a business has high debt ratios, then the times-interest-earned ratio is low since it would be more difficult to pay its interest expenses if it has a lot of debt. On the other hand, if the company's debt ratios are low, then the times-interest-earned ratio would be high as it would be easier to cover the company's interest expenses.

The numbers for the TIE ratio come from your company's income statement.

The TIE calculation looks like this:

EBIT / Interest Expense

Let's say last year your company's EBIT was $691 and your interest expense was $141:

$691 / $141 = 4.9

The TIE is 4.9, which means that your company can meet its interest expenses 4.9 times over each year. We don't know if that is good or not without something to compare it to and we don't have comparative data. However, it is good to know that your business can pay its interest expense at least more than one time over each year.

Debt Management Ratios and Financial Health of a Business

We've calculated the three most important debt management, or financial leverage, ratios to determine your business' debt position.

If you see that your business is using less debt now than in past years, that's often a positive sign for the company's financial health. More debt means more risk. More debt also usually means that the company has less cash available to pay its suppliers and for general operations since it has to cover its interest expense. If your small business is relying more on owner financing now, that's a positive sign.

Frequently Asked Questions (FAQs)

What is a debt management ratio?

A debt management ratio tells you how much of your company's operations are based on debt rather than equity. The debt could be a loan that you took out for your business. Since it's a loan, you have to pay it back, so your company may not actually be making any money since any profits will need to go toward paying back that debt. Equity would be your own money in the business.

What are the common debt management ratios?

Common debt management rations include the debt-to-asset ratio, the debt-to-equity ratio, and the times interest earned (TIE) or the interest coverage ratio. These will tell you if your business is losing money and heading toward bankruptcy, or if your business can cover its interest expense on debt and pay it back.

Article Sources

  1. Iowa State University. "Financial Ratios."

  2. Ohio University. "Why the Debt-to-Equity Ratio Matters in Capital Structure."