Debt to Equity Ratio Simplified
Without a little background, financial formulas like Net Present Value, Internal Rate of Return, Net Operating Profit and Debt-to-Equity ratio can feel like those math problems that Matt Damon solved in Good Will Hunting. In reality, these formulas are generally quite simple and you don’t need to be a math protégé working as a janitor.
DEBT TO EQUITY RATIO (D:E)
Why Is It Important - Debt is inherently risky and debt repayment can be major financial strain on your practice’s cash flow. For investing purposes, a company with a lower debt-to-equity ratio is considered more stable as it could survive a cash flow crunch caused by a recession.
Similarly for your practice, the debt-to-equity ratio will give you a quick understanding of your financial stability and your ability to take advantage of opportunities.
Most dental practice purchases are 100% financed by a bank, so your debt-to-equity ratio will be huge during the early stages of ownership. The goal over time is to reduce that ratio down by paying off debt and keeping more cash reserves in the practice.
How to Calculate - Any ratio is simply one number divided by another so calculating your debt-to-equity ratio (D:E) is simple math:
Total Debt divided by Total Equity
Total Debt is the total amount of money that you owe to other people and institutions. In your practice, it is probably a simple combination of the current credit card and loan balances.
Total Equity is the combination of money you put into the business plus any profits you have not taken out of the business. For your practice, this amount can vary widely based on your career stage and personal cash needs.
What should be my goal ratio? - As mentioned above, the D:E number can vary significantly based on where you are along the practice ownership timeline. Here are some timeline goals that we like to use:
Early Phase. In the first three years, you are still learning how to be boss, developing your practice vision and culture and just trying to keep your head above water. Since you likely took out a big loan to purchase a practice or start your own, a D:E under 20 is acceptable.
Mid-Phase. Once you get through the first few years and build up momentum, you can start focusing on paying down debt and building up cash reserves. This phase of your career might be 10 to 20 years long and the goal is to move your D:E number down to under 2.
Final Phase. This is the last 10 to 15 years of your career where debt has been paid off and the practice is allowing you to accumulate wealth until you reach the point where continuing to work becomes optional. During this phase, you will still have a credit card balance and an occasional short-term loan for new equipment but the D:E goal should be less than 1.
Each practice and D:E ratio is different so if you have questions on your specific situation, please schedule a consultation with JNG Advisors today to calculate your debt-to-equity ratio and discuss the implications for your practice finances.