Expert: Michael Fay - 6/19/2009

Question
h r u sir
In the business which debt to equity ratio is better to make the business successful in the long term

Answer
Answer:
All of the ratios will be important to the long term success of the business, not just those that evaluate debt to equity.  Even within these ratios there are ways to manipulate the numbers.  For example the owners could loan the business money instead of investing it as capital.  The source is the same – namely internal – but the accounting treatment is different.  Even then there are different treatments such as subordinating that debt.

For your question about the specific measurements, I’m not sure that I could point to one correct answer because industries vary.  So I will give you two good rules of thumb across many types of businesses

1.  Current Liabilities should be less than the Equity of the owners.  
     If you want a target number to shoot for, keep it between 75% and 85%

2.  The difference between the LT Debt and Short Term Debt ratios is generally assumed to reflect the interest expense which can become very non productive use of funds if left unchecked.  Note that this general opinion is misleading if the Current Liabilities includes a high amount of credit card debt.  

** Now for the opinion part **

I don’t think it matters whether you use long term or short term debt ratios.  The reason is that when I or others evaluate a financial statement we may not always use the same debt classifications that the accountant uses, just remember some of the manipulations noted above.  So what might have been prepared with an eye towards a stable target ratio may be picked apart and tell a different story.  The bigger question is “Is there a positive net worth?”  But even that can vary for tax reasons and the advice of the accountant.

If you are looking to measure long term success and want to include debt measurements as part of that evaluation let me suggest some alternatives; again remember that these will vary by industry and are also subject to manipulation and reclassification.  Debt ratios are snapshots at a point in time.  The final two ratios below include Sales figures.  Sales tells story over the whole year and this gives a better measure of long term success.

a1) Current Ratio.  (Current Assets divided by Current Liabilities)  As long as the quick ratio or “acid test” is not totally anemic, this is usually a better indication of your debt load.  Most financial analysts will tell you that CA should be twice CL.  I don’t know if it needs to be that high

a2)  Sales to Working Capital – a slight variation on the above.
  Measured as [Sales divided by (Current Assets less
  Current Liabilities)]  or Sales/ (CA-CL).  
When this measure is too high, that is a sign of excessive debt and an indication of insufficient operating funds.  

b) Accounts Payable to Sales.  If sales are too low this will indicate that your suppliers are the ones financing the business (and consequently the one really profiting from it as well).  That is not a good sign for long term success.


I know you were looking for a magic bullet and I’m sorry I couldn’t give you one.  Numbers can often be made to say anything that people want them to (just look at the politicians!)  The important thing is to know what is driving the numbers to understand what they really represent.