Debt is normally something most small business owners try and avoid at all costs. However, a healthy business can support debt which then provides it enough cash to grow.
The measure to help you work out what’s the right level of debt for your business is the debt-to-equity ratio, which a measure of 1 to 1.5 generally considered healthy (though this benchmark varies significantly across different sectors and industries).
Capital-intensive sectors like manufacturing often maintain higher ratios exceeding 2, whilst technology companies might operate comfortably with much lower levels.
We’ll help you calculate your debt-to-equity ratio, understand the results for your industry, and identify the warning signs of unhealthy debt levels. Whether you’re running a start-up or an established business, we’ll help you understand exactly what makes a healthy debt-to-equity ratio for your business.
Using debt in your business
The UK’s business lending landscape has undergone substantial changes over the past decade. Since 2014, 60 new banking licences have been granted, with 36 specifically serving small businesses. This shift has notably altered the market dynamics, as the five largest banks’ lending share decreased from 63% in 2014 to 41% by 2023.
The changing landscape of business borrowing
The total stock of bank lending in 2023 stood at £185 billion, although this marked a 12% decline in real terms compared to 2022. Additionally, the flow of bank lending fell to £59.2 billion in 2023, representing a 15% decrease from the previous year.
Using external finance in smaller businesses has grown, increasing from 41% in Q1 to 50% in Q3 of 2023. Particularly noteworthy is the rise in credit card usage, which climbed from 12% to 20% during this period.
Asset finance has demonstrated consistent growth, reaching 26% higher levels in 2023 compared to 2014. Furthermore, challenger banks have surpassed traditional institutions, collectively maintaining a larger market share than the big five banks for the third consecutive year.
Why some debt is essential for growth
Strategic debt can serve as a vital tool for business expansion and sustainability. When managed properly, debt enables companies to fund strategic investments, expand or enter a new territory or market, buy or upgrade equipment, start research and development, or acquire property to help long-term stability.
Good debt is characterised by its planned nature and clear investment purpose. For capital-intensive industries such as manufacturing, maintaining higher debt ratios exceeding 2 is common practice. Conversely, technology companies operating online typically function with lower debt levels.
The British Business Bank’s data indicates that working capital remains the primary motivation for seeking external finance, with 53% of SMEs citing this as their main reason and 27% of businesses sought funding for fixed assets and business growth investments.
The lending landscape offers more options than ever before, particularly through alternative financing routes. This includes peer-to-peer lending, crowdfunding, and fintech solutions, which have become increasingly significant for SMEs facing challenges with traditional banking criteria.
Importantly, 80% of SMEs that accepted external finance in 2022 expressed confidence in their ability to meet repayment obligations. The value of external finance typically correlates with business size – medium-sized companies often seek around £300,000, whilst small and micro businesses generally apply for £50,000 and £24,000 respectively.
Calculating your debt-to-equity ratio
Understanding your debt-to-equity ratio starts with mastering a straightforward calculation that reveals crucial insights about your business’s financial health. Let’s break down this essential metric step by step.
The basic formula explained
The fundamental calculation divides your total liabilities by shareholder equity. Here’s the formula:
Debt-to-equity ratio = Total liabilities ÷ Shareholder equity
To illustrate this, imagine a cake-making business that owes £4,000 to suppliers and has £3,000 in shareholder equity. Upon applying the formula, we get a debt-to-equity ratio of 1.33.
What to include in your calculations
Your total debt should include:
- Short-term liabilities
- Long-term liabilities
- Accounts payable
- Accrued liabilities
- Deferred tax obligations
- Bonds payable
- Mortgages
- Lease arrangements
Accordingly, shareholder equity represents the difference between your company’s total assets and liabilities. In essence, it’s what remains for owners after settling all debts.
Common calculation mistakes to avoid
First, avoid focusing solely on the numerical result without considering industry context. A ratio that seems concerning in one sector might be perfectly acceptable in another. Subsequently, manufacturing and capital-intensive industries often maintain higher ratios due to substantial equipment investments.
Another frequent oversight involves excluding certain debt obligations. Some businesses mistakenly omit non-interest-bearing liabilities like accounts payable from their calculations. Therefore, it’s essential to include all relevant debt components for an accurate assessment.
Short-term liabilities warrant special attention. Even though they’re typically less concerning because they’re settled within a year, a high proportion of short-term debt could raise red flags if your company struggles to meet immediate obligations.
For precise calculations, consider using financial software or spreadsheet templates. Microsoft Excel offers balance sheet templates that automatically compute your debt-to-equity ratio. Otherwise, you might create a simple spreadsheet by entering total liabilities and shareholders’ equity in adjacent cells, then using the formula “=B2/B3” to calculate the ratio.
Remember that not all debt carries equal risk. Long-term debt typically costs more than short-term borrowing and shows greater sensitivity to interest rate changes. Consequently, two companies with identical debt-to-equity ratios of 1 might face different risk levels depending on their debt composition.
For instance, if a company has £158.83 million in total debt and £79.42 million in shareholders’ equity, their debt-to-equity ratio would be 2.0x. This means for every pound of equity, the company carries £2 in debt. Understanding this relationship helps assess your financial leverage effectively.
Industry-specific debt ratios
Debt-to-equity ratios vary across different sectors of the UK economy, reflecting diverse capital requirements and operational models. Understanding these industry-specific benchmarks helps business owners make informed financial decisions.
Manufacturing and retail benchmarks
Manufacturing businesses often maintain higher debt levels, primarily as they require substantial capital investments in plant, equipment, and machinery. As of 2024, the manufacturing sector accounts for 8.8% of total UK economic output. The sector’s total borrowings of £190 billion represent gearing of 28% against total assets and 73% against net worth.
Capital-intensive manufacturing companies frequently operate with debt-to-equity ratios exceeding 2. This higher ratio stems from their need to finance extensive physical assets and operations. Nonetheless, debt appears manageable within the sector, as evidenced by a slight reduction from £191 billion in December 2023 to £190 billion currently.
Retail businesses, on the contrary, typically maintain lower basic debt-to-equity ratios. Still, retailers might carry ‘hidden debt’ through operating leases, depending on their accounting standards. The average debt per manufacturing company stands at £2.49 million.
Service industry standards
Service-oriented businesses demonstrate distinct debt patterns from their manufacturing counterparts. These enterprises typically require less capital investment, enabling them to operate with lower debt-to-equity ratios.
The financial services sector presents an interesting exception. Despite being service-based, financial institutions often maintain higher debt ratios, occasionally surpassing 2. This unique characteristic stems from their business model, which inherently involves managing substantial financial assets and liabilities.
A crucial consideration for service businesses involves examining industry-specific benchmarks rather than pursuing a universal standard. For instance, a debt ratio exceeding 3 might raise concerns, unless the industry average hovers around 5.
Tech sector expectations
Technology companies, especially those focusing on software and services, typically maintain lower debt-to-equity ratios. This trend reflects their asset-light business models and primary reliance on intellectual property and human capital rather than physical infrastructure.
The tech sector’s unique characteristics include:
- Lower capital requirements for daily operations
- Reduced need for physical infrastructure
- Higher profit margins enabling self-funded growth
- Greater emphasis on equity financing
Advanced manufacturing companies within the tech sector face distinct challenges. These firms often struggle to secure investment, especially during scale-up stages. This difficulty stems from:
- Longer timeframes to profitability
- Higher technology risks
- Less predictable financial returns
- Complex nature of advanced manufacturing technologies
Ultimately, rather than pursuing an arbitrary ‘ideal’ ratio, businesses should evaluate their debt levels against industry averages and competitor benchmarks. This approach provides more meaningful insights into financial health and sustainability. For capital-intensive industries, ratios approaching 2 or 2.5 might indicate stability, whilst technology firms might thrive with significantly lower levels.
Warning signs of unhealthy debt levels
Spotting financial distress early can mean the difference between business survival and failure. With UK corporate insolvencies reaching their highest annual numbers since 1993, understanding the warning signs of unhealthy debt levels has become increasingly critical.
Key red flags to watch
Financial strain often manifests through several clear indicators. Initially, businesses might notice consistent late payments to suppliers or creditors. A concerning trend emerges as 33% of SMEs now maintain debt levels exceeding 10 times their cash balance.
Cash flow problems typically surface first, with these key indicators:
- Monthly debt repayments consuming more than 15% of income, affecting 18% of SMEs
- Regular bouncing of transactions or exceeding overdraft limits
- Delayed payments to HMRC or other statutory obligations
- Reduction in turnover or order book volume
Most alarmingly, 10% of SMEs currently face both high debt levels and elevated debt repayments. Furthermore, the proportion of SMEs in arrears on loan repayments has increased from 0.9% to 1.2% for commercial loans.
Impact on business operations
Unhealthy debt levels create a domino effect across business operations. Firstly, suppliers might terminate contracts or refuse to extend credit, leading to operational disruptions. Businesses often find themselves diverting cash meant for growth towards immediate needs, including paying suppliers, meeting payroll or covering essential overheads.
The strain becomes evident as debt-servicing pressures mount, particularly among SMEs in specific sectors. Markedly, the 95th percentile has seen pronounced increases in debt service ratios across accommodation and food services, construction, retail, transport, and professional services.
These pressures affect business stability. The Bank of England reports that financial stability risks have increased “moderately” as a result of higher corporate debt. Straightaway, this impacts employment levels and household incomes, potentially slowing overall economic recovery.
For businesses approaching critical levels, debt can create a vicious cycle. As cash flow decreases, making debt payments becomes increasingly challenging, often leading to the need for additional borrowing. Simultaneously, this pattern typically results in:
- Reduced investment in growth initiatives
- Cutbacks in research and development
- Limited marketing expenditure
- Restricted expansion plans
Recent data shows that more than 47,000 UK businesses started 2024 facing potential collapse, following a 25.9% jump in ‘critical’ financial distress. Likewise, significant financial distress now affects 539,900 UK businesses, marking a 12.9% increase from the previous quarter.
Smart debt management strategies
Proper debt management forms the cornerstone of business sustainability. Recent data from the Bank of England shows that small firms have significantly increased their debt levels through the pandemic, making strategic debt management more crucial than ever.
Balancing growth with stability
A well-structured debt management approach starts with understanding your company’s financial obligations. Small and medium-sized enterprises should categorise their debts into short-term and long-term liabilities. This classification helps prioritise repayments based on interest rates and urgency.
To maintain stability whilst pursuing growth, businesses should focus on:
- Reviewing receivables through early payment discounts
- Managing inventory to free up cash
- Exploring asset finance options
- Considering equipment leasing instead of purchasing
The British Business Bank reports that working capital remains the primary reason for seeking external finance, with 53% of SMEs citing this as their main motivation. Hence, balancing these needs with existing debt obligations becomes paramount.
When to restructure debt
Restructuring becomes necessary upon identifying specific triggers. The Financial Conduct Authority (FCA) suggests considering debt restructuring when:
- Monthly debt payments exceed 15% of income
- Regular breaches of overdraft limits occur
- Delayed payments to HMRC become frequent
A formal restructuring plan might prove beneficial if your business faces financial difficulties yet remains viable for rescue. This approach enables companies to:
- Compromise on debt amounts
- Implement debt-for-equity swaps
- Reset financial covenants
- Reschedule debt repayments
Importantly, 75% approval by value from affected creditors typically suffices for restructuring plan implementation. Through the ‘cross-class cram down’ mechanism, dissenting creditors can be overruled by court approval if the plan offers better outcomes than alternative processes.
Building a debt management plan
Creating an effective debt management plan requires systematic approach. MoneyHelper emphasises starting with a comprehensive assessment of your financial situation. This involves:
Step 1: Document all debts, including:
- Short-term obligations
- Long-term liabilities
- Accounts payable
- Deferred tax obligations
Step 2: Engage with creditors early if anticipating repayment difficulties. The Business Debtline suggests maintaining transparent communication about challenges.
Step 3: Consider professional guidance. Currently, 37,000 businesses receive expert debt advice annually. Free debt management plans through organisations like StepChange can ensure all payments go directly towards debt reduction.
For optimal results, involve your leadership team in debt management decisions. This integration ensures debt management aligns with overall business strategy rather than being treated as an isolated financial issue.
Remember that debt management plans typically cover ‘unsecured’ debts exclusively. Secured obligations, including property-backed loans, require separate arrangements. Furthermore, maintaining regular payments proves crucial, as defaulting can lead to plan cancellation.
Understanding and managing business debt
Understanding and managing business debt requires careful consideration of industry-specific factors rather than following universal rules. Though a debt-to-equity ratio between 1 and 1.5 serves as a general benchmark, manufacturing companies often thrive with ratios exceeding 2, while technology firms maintain significantly lower levels.
The UK’s lending landscape offers more options than ever before, with challenger banks now holding larger market shares than traditional institutions. This shift has created new opportunities for businesses seeking external finance, particularly through alternative lending routes.
Smart debt management starts with recognising early warning signs and taking prompt action. Regular monitoring of key financial indicators, along with maintaining open communication with creditors, helps prevent minor issues from becoming major problems. Additionally, creating a structured debt management plan aligned with your business strategy ensures long-term sustainability.
Ultimately, healthy business debt supports growth when managed strategically. Your focus should remain on maintaining debt levels appropriate for your industry while building strong financial foundations through careful planning and regular review of your debt-to-equity position.
FAQs
Q1. What is considered a healthy debt-to-equity ratio for UK businesses? While a ratio between 1 and 1.5 is generally considered healthy, this can vary significantly by industry. Manufacturing companies often operate well with ratios exceeding 2, while technology firms typically maintain lower levels.
Q2. How has the UK business lending landscape changed in recent years? The UK lending market has diversified, with challenger banks now holding larger market shares than traditional institutions. Since 2014, 60 new banking licences have been granted, with 36 specifically serving small businesses, offering more options for external finance.
Q3. What are the warning signs of unhealthy debt levels in a business? Key red flags include consistent late payments to suppliers, monthly debt repayments exceeding 15% of income, regular breaching of overdraft limits, and delayed payments to HMRC. Additionally, a reduction in turnover or order book volume can indicate financial strain.
Q4. When should a business consider debt restructuring? Debt restructuring should be considered when monthly debt payments consistently exceed 15% of income, there are regular breaches of overdraft limits, or delayed payments to HMRC become frequent. It’s also worth exploring if the business is facing financial difficulties but remains viable for rescue.
Q5. How can UK businesses effectively manage their debt? Effective debt management involves categorising debts, prioritising repayments based on interest rates and urgency, and exploring options like early payment discounts or asset finance. It’s crucial to maintain open communication with creditors and consider professional guidance when needed. Regular monitoring of financial indicators and aligning debt management with overall business strategy are also key.
