Managing an Optimal Debt Ratio

From paying off credit card bills and auto loans to refinancing home mortgages, we live in a highly sophisticated financial environment.  In a series of open lectures from Yale University, Professor Robert Schiller mentioned that finance is perhaps the pinnacle of human civilization- it allows the flow of capital to construct roads and buildings, develop ideas into products, and sow crop to harvest later.  Without the advancement of finance, much of today’s industrialization's would not exist.  It’s a bold claim, but think about a world without “money”.  How about a society without banks?  Carrying loads of cash instead of a few plastic cards?  Not having finance in our lives makes me shudder.

In a business perspective, finance goes beyond checking on cash flow, revenues, and expenses.  The essence of finance comes from actively managing various accounting ratios. Plainly speaking, the business owner should plan ahead which key projects will require additional capital (in the form of loans), where to find those funds (Small business loans? Alternative financing? Venture Capital?), and how much debt the company should carry.  For most small to medium US businesses, the debt-to-equity ratio is on average below 1.5 and it is inadvisable to have any greater debt as it increases risk of delinquency. 

One recommendation is to investigate financial statements of publicly traded companies (easily accessible online through websites such as marketwatch.com or Yahoo Finance) that play in the same industry as your business.  Every industry reports varying degrees of leverage ratios, and it will help you obtain a general idea of an optimal debt amount.  Unfortunately, no straightforward formula or answer exists in how much debt you should carry.  Rather, making several key assumptions such as the rate of estimated return on your funded investment drives your financing decision. 

I’ve seen small business owners and individuals who were completely averse to debt, to a point as to not use credit cards at all.  While some have been moderately successful with such strategy, I can only wonder what great success they may have gained with applying their strong discipline to actively financing new growth opportunities.