An important part of analyzing the health of a business involves taking a look at its debt-to-equity ratio. A company’s debt-to-equity ratio tells analysts and prospective investors how much debt a company holds relative to its assets. This is expressed by the following formula:
Debt-to-equity ratio = Total Liabilities / Total Shareholders’ Equity (i.e. assets minus liabilities)
Analyzing a company’s debt-to-equity ratio is helpful because it tells investors how efficiently a company is running its business. In an article for Harvard Business Review, Amy Gallo explains that “if your debt-to-equity ratio is too high, it’s a signal that your company may be in financial distress and unable to pay your debtors. But if it’s too low, it’s a sign that your company is over-relying on equity to finance your business, which can be costly and inefficient.”
Many of us have heard from our grandparents, especially those of us who have relatives who lived through the Great Depression, that we should avoid debt at all costs. In a debt-saturated country such as ours, this is not necessarily a bad thing for us to hear. While keeping debt low is usually a sign of financial health, there are cases when having too little debt, or not making efficient use of debt, can be detrimental to one’s financial success. Just as a company needs to make efficient use of debt in order to grow, an individual can, and often should, do the same thing. A similar formula can be expressed for individuals:
Debt-to-equity ratio = Total Liabilities / Total Assets
I have clients, for example, who have accumulated significant estates and who are in a position to grow them. The germane question then becomes whether or not it makes sense for them to do so using their own money or someone else’s. Even though one may be in a position to pay cash for an investment, it doesn’t always make sense to do so. This is especially the case in low-interest rate environments such as the one in which the present U.S. economy finds itself.
While one could pay cash for a rental property, for example, it might make more sense to borrow the funds. If, for example, interest rates are at 4.75%, an investor could borrow the funds to purchase the property and then take the cash they would have used for the purchase of property and invest it in something else that has the potential of earning a higher rate of return. In this scenario, an investor might be able to earn enough of an additional return to pay the 4.75% interest rate on the loan while still having funds invested in an investment with a higher rate of return. These funds could then be used to eventually pay down the existing debt, especially if interest rates increase, or they could be used to make additional investments in an effort to grow the investor’s estate or fund another financial goal (In the business world, the additional funds might be used for such endeavors as starting another business, adding a location, or perhaps hiring more employees).
How much debt can one reasonably take on while still maintaining a healthy personal balance sheet? There is no definitive answer to this question. Factors such as the size and composition of one’s estate, one’s ability to tolerate risk, one’s life-stage, income level, and overall financial goals all need to be taken into consideration. Assessing one’s ability to tolerate risk is of utmost importance because, if one were to lose the additional funds that could have been used to purchase the original investment, then the investor is left with a debt burden that would not have been present had cash been used to make the original purchase.
Assuming, however, that one is in position to make judicious use of borrowed money, there are some figures that can be helpful. I recently spoke with a colleague who has been in the lending business for fifteen years, and he suggested as a general rule of thumb for individuals a debt-equity-ratio of 65%. In other words, one would not want one’s debt to exceed 65% of total assets. A more conservative investor might even want to bring this figure down to around 50% or lower. Again, it’s important to emphasize that we’re talking here about the use of debt for investment purposes, not about having 50% of one’s debt in credit cards or other frivolous types of debt.
To sum up, debt is not always a bad thing. Sometimes, the best thing to do when trying to grow one’s estate is to make sensible use of borrowed money. Companies make efficient use of financing, and individuals can, and often should, do the same thing.