A Company's Debt to Equity Ratio is Important to Calculate
You might open your business on a shoestring budget and bootstrap your startup. That could get you into the black and keep you there. Chances are good though that you will need a major monetary infusion at some point to really grow your business.
At that point, you either need to attract angel investors, venture capitalists or take out a loan. As different as the process of obtaining funding is using any of these three options, they all have one thing in common. Each of the methods looks at your debt-to-equity (D/E) ratio to determine the fiscal health of your company.
Debt To Equity Ratio (D/E Ratio) Defined
Financial institutions and potential investors use the debt to equity ratio to evaluate a business’s financial leverage. You can easily calculate this ratio by dividing the total liabilities of a business by its shareholder equity.
In corporate finance, this metric shows whether the company finances its operations via debt or wholly-owned funds. If the business crashed tomorrow, you could forecast whether it would survive based upon whether its shareholder equity could pay its outstanding debts.
A low ratio indicates a healthy business that can rely on its own money and holdings if it needs to suddenly repay debt or finance itself.
A higher ratio indicates that a business or its stock presents a high risk to shareholders.
Sometimes, investors calculate themselves to differentiate between debt types. They focus only on the long-term debt which presents a different type of risk than payables and short-term debt.
You can find this basic calculation on a business’s balance sheet. A company’s balance sheet shows the total shareholder equity as equal to the company's assets less its liabilities.
Now, they do not take the ratio by itself because no one statistic accurately explains a business. You need to look at its entire portfolio and its financials, as well as how its sales have progressed. Some investors may also look at altering the D/E ratio by including growth forecasts, short-term leverage ratios, and profit performance.
Another valuable reason for looking at the company holistically is that it distorts the picture vis a vis intangible assets, retained earnings or losses, as well as pension plan adjustments. You won’t understand the business’s actual leverage ability until you build a holistic picture of its finances and forecasts.
How Hard Is It To Find Out a D/E Ratio?
Probably the easiest way to learn the D/E ratio of a business is to use the Microsoft Excel balance sheet template. You enter the essential numbers for the business into the spreadsheet and it calculates them for you automatically. The program offers a number of financial templates that you can use to determine how healthy a business is before you sink any money into it.
What does the D/E ratio really tell me?
Smart investors want low-risk, high-return investments. A D/E ratio tells you how smart and savvy the business owner is. A high ratio simply means that the business owner took out a loan every time they needed money.
Instead of cutting back on expenses or taking on more work or attracting angel investment or venture capital, the business used the quick option of taking out a loan. Taking out a loan also means they chose the most expensive option.
Taking on debt creates risk. Think about it in terms of your own finances. If you own your house and your car outright, that means you have no payments you must make each month to have a roof over your head and a vehicle to use to get to work and run errands. Let’s say a major pandemic occurs. Not totally outside the realm of possibilities. Throw me a bone that it isn’t too Orwellian.
Everything shuts down for nearly a year. Your employer lays off everyone – even the company’s leadership positions. Public transportation shuts down. Borders close. You cannot drive to the next state to see your relatives.
Things get real – really quick.
You put yourself in a less risky position since you own your home outright and your car. You have no regular debts to pay.
Let’s go one further. You have no credit cards and you simply saved up money in the bank and in your investment portfolio.
While your neighbor down the street may have a mortgage or rent, a car payment, and a few credit cards, you are sitting pretty.
The two of you both apply for the same remote job. The employer checks backgrounds and runs a credit check. You pass with flying colors because you have a very healthy debt-to-equity ratio. Yep. Individuals have a D/E ratio, too.
Just as an employer looks at which individuals make the better life choices, your choices for your investment portfolio should do the same.
It’s My Business And My D/E Ratio
Oh, ick. Okay, well, you can save your ratio rather easily, actually, using many of the same methods you would to save your personal financial scores.
Take stock of your finances. Look at what you borrowed. Why did you borrow it? Did you need to buy equipment, expand the space you own or hire new people? How quickly did you determine they would pay for themselves?
What can you do now, starting today, to make more money? Could you introduce a new product or service with only what you have right now and without incurring any debt whatsoever?
Brainstorm this.
You could potentially add tiers of service. Perhaps you can make what you offer accessible on a smaller or larger scale. Look at where the largest market exists that needs a product or service you already offer, but on a different scale. Maybe you offer an enterprise product and corner the market but offer nothing to small businesses, yet they need the same service.
Paying off debts quickly. What does your company owe that you could pay off really fast? Could you sell old, unused equipment or offer part of your space for rental? Any option that does not negatively impact your business but makes you legal money could work.
Look at one of the smartest nerds around, this guy named Elon Musk. He has created fun products he could sell quickly, largely to other nerds, that funded his projects. Although he has become best known for Tesla cars and space ships, he makes baseball caps, too. He quite seriously funded a project in the past three years by creating branded caps and selling them. They sold out and he obtained his funding without debt. It also helped him from a marketing perspective, since now hundreds of thousands of people wear hats for his company. He gets advertising from his branding and funded the project. Now, that’s using your genius IQ!
The upshot is that your product or service does not have to be something completely in line with what you already offer. It could enhance something you already sell. For example, you can buy branded Tesla keychains and use them for the keys to your snazzy Tesla.
Re-direct funds. Can you avoid paying yourself for a month? Re-direct that money to your debts. As a business owner, you probably have money in your personal savings that you could live off of for a month. The quicker you can pay down your company’s debt, the better your D/E ratio will be.
Although it remains perilously close to a typical loan, you could, in a pinch, use accounts payable financing or invoice financing to quickly obtain funding to pay off a traditional loan. This form of credit uses what your clients owe you that won’t get paid to you until the end of the month as collateral for that amount now. When your clients pay you, it goes directly to the lender to repay them.
Why the heck would you do that? Because it typically won’t show up in the calculation, so you pay off the traditional loan that is sucking you dry with its high-interest rate.
You then have improved your D/E ratio, so you can apply for a low-interest loan through a Small Business Administration program. This lets you reduce your loan amount. Maybe you no longer need the loan. You pay it back quickly and you suddenly look really great to investors. That could cause your stock price to increase.
Long-Term Solutions
Yes, businesses need to grow, but you need to find a way to obtain the money to expand without taking on debt.
The only long-term solution is for you, the business owner, to learn to make money with the money you make.
You need to finance your business’ growth using financing you do not need to repay.
Work on updating your business plan. Court some angel investors or venture capitalists. Take on a silent partner or offer a partnership buy-in to a qualified competitor or business partner.
You need to learn to savvily expand your business. Plan ahead. You know you want to grow, so start saving money to fund that growth. Invest in your business’s growth by creating a business savings account and setting up an automatic deposit for it. Pay it the way you pay yourself in personal finance every month.
Within one year, you should be able to save some expansion funding. This works most effectively as a method for small- to mid-sized businesses. That’s because large corporations have already IPO-ed and their stock sales help them fund their business.
Finally,
You can learn more ways to keep your business healthy. You can also learn how to invest savvily. You learn both at the same spot online – the Goalry family of websites. Sign up for a member key today. It costs you nothing and you gain access to a plethora of financial education articles and tools to help you learn and grow.
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