Everything You Always Wanted to Know About Debt-to-Income Ratio but Were Afraid to Ask
Editor’s Note: This is one of an eight-part series about key financial terms all entrepreneurs should know.
Your company’s debt-to-income ratio (DTI) is quick and easy to calculate, and it can tell you a lot about your financial situation. Many entrepreneurs look at this key performance indicator (KPI) for their businesses and their personal finances each time new recurring debt is added or subtracted. Be warned: calculating it may even become somewhat addictive!
What is debt-to-income ratio?
Debt-to-income ratio is exactly what its name implies: A measure comparing the percentage of a company’s debt to its overall income. It is calculated by dividing total recurring debt by gross income. It’s most commonly calculated and shown on a monthly basis, but DTI can be expressed over any period of time.
Why is debt-to-income ratio important?
Debt-to-income ratio is important because it is an indication of how much money is left over after your obligations are paid. This money may be used to promote or grow your business, allocated toward purchases or improvements, or taken as earnings.
The lower your debt-to-income ratio, the smaller your debts are compared to your overall income. That’s why higher DTIs are less attractive to entrepreneurs and their potential investors. The best way to lower your DTI may be to pay off recurring debt or costs, although doing so isn’t always advantageous. Talk to your accountant or CFO if you have questions about your DTI.
How can debt-to-income ratio impact your ability to raise capital?
All lenders will consider your DTI before making a funding decision, because DTI allows them to determine your ability to pay back additional debt. Traditional lenders want to ensure you’ll be able to meet the repayment obligations of your agreement. Equity investors, who may not be recouping money in the immediate future, want to ensure you’re not seeking a capital infusion just to repay existing debt. DTI is an important metric for determining your company’s runway, or the amount of time your business can continue to survive if your income and debts stay the same.
Ask an Expert
How often should entrepreneurs be analyzing their debt-to-income ratio?
The debt-to-income ratio should only increase when you add additional monthly payments (debt) to the company. Thus, it is an indicator that can be analyzed when new debt is being considered or as a baseline each month, quarter, and year. In this way you can baseline your revenue growth over your monthly debt payments. It is a KPI that is of value to have included with your period reporting (month, quarter or year) but likely does not need to be considered more than that.
Does the percentage of acceptable debt-to-income ratio vary by industry?
Absolutely. Industries which require higher fixed asset purchases, such as manufacturing or construction, would generally have a higher debt-to-income ratio. However, they have hard assets that support the debt. A service-based company would be expected to have lower debt levels in relation to its income. Each case is different and there is no generic template that can be provided. Everything from newness of the market, industry benchmarks, internal finances and growth projections should be considered when determining where a company’s acceptable target is.
You can walk the walk, but do you talk the talk? If you’re trying to secure funding for your startup, it’s important to be well-versed in financial lingo. Check out part 2 of this series where we discuss current ratio.