Running your own business and finding success is the epitome of the American dream, and few things in life are more satisfying or more rewarding. However, one of the greatest pitfalls any small business owner can run into (and what causes a lot of owners to close their doors) is letting their debt to income ratio tip too far onto the “debt” side of the scales.
Some amount of debt is almost unavoidable, necessary, even, to keep your business running, growing, and healthy, but a little can lead to a lot and things can get out of hand fast. Because of this, today we’re going to give a brief overview of what a debt to income ratio is, how to measure it, and some tips for managing it. Let’s get started.
What Is A DTI?
Debt to income (DTI for short) is a deceptively simple term that measures all of an entity’s debt and overhead on one side, and stacks it against the same entity’s earnings on the other side. It’s “deceptively” simple because the things that fit into each of these two columns may not be obvious. Keeping a hold on this measurement is often the fundamental difference between a healthy business and one that may soon have to close its doors.
Many business owners prefer to consult a financial professional. Their help allows entrepreneurs to fully calculate a debt to income ratio. You may also get a basic sense of your own ratio with some relatively simple math. First take a full accounting of the two “columns” we discussed above. Divide your total liabilities by your income. “Liabilities” means any expense, loans, personal or business credit card debt, or obligation your business experiences in its lifetime. This can even include prospective liabilities over a period of time. Your total business incomes are the sum of any earnings or other sources of revenue your enterprise receives.
Do Businesses Face Liabilities?
There are common liabilities businesses face. These include operating costs such as utilities, insurance, payroll, loans, and other general expenses you would report in your taxes. Incomes are much more simple and are limited to the money you put into the business yourself, revenue from sales and services, and the sums you receive from loans.
You may note that among the liabilities we did not list manufacturing costs. This is because you can simplify your calculations by subtracting this total from your income. This leaves you with the net value you will use on the income side of your calculations.
There may be some cases where you won’t do this. For example, if you were to take a loss on manufactured goods or were not selling enough goods to overshadow manufacturing costs. However, as long as your income covers your investment into goods and services provided, you can just subtract the cost from the income before calculating your DTI.
Managing Your DTI
Once you total your two columns and divide the liabilities by the incomes, you may or may not be pleased with your initial findings. At this point, you may want to consult a financial advisor. However, there are some general tips you can follow to improve your overall DTI ratio.
Consider how you can lower the liabilities column to a healthy level, and ensure you are making a profit. You can achieve this by making cuts to payroll, modifying operating hours, cutting expenditures into things like advertising and insurance. You may also add or pay off loans to maneuver your total amount of cash on hand.
Why Debt To Income Ratios Matter
Managing your DTI is one of the fundamental aspects of ensuring the long-term success of your business. As a small business owner it is of the utmost importance that you keep your personal DTI ratio where it needs to be.
You can make a rough, personal accounting of your DTI with some simple calculations. Did you find yourself in a bad spot? It may be in your best interest to take actions to improve your DTI. Consult a financial advisor to help you bring your business back into the black.
Irene Malatesta is a business content strategist with Fundbox. This company works with entrepreneurs and mission-driven businesses to bring their stories to life. Fundbox helps small businesses grow by democratizing access to credit.
Fundbox and its affiliates do not provide tax, legal or accounting advice. This material is for informational purposes only. It does not provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.