There comes a time in the lives of small creative business owners when they have to consider raising capital from the market. It could be to expand their business or launch new products to meet the increasing demand from the customers. While such news is often fulfilling, it can also lead to sleepless nights, and rightly so.
After all, approaching investors or lenders for investment capital is not easy, especially so when you define yourself as a creative person with little exposure to the workings of a business. However, the knowledge of accounts and bookkeeping is an essential part of running a successful business.
A particularly important financial concept that can help you in a situation where you are seeking more investment capital is the debt to equity ratio. This ratio represents the financial standing of your company.
You don't have to book an appointment with your accountant to understand the term. We have explained the content of the debt to equity ratio for you below.
You can calculate your business' debt to equity ratio (D/E) by dividing the total liabilities by shareholders' equities. In other words, it is represented by the total debt divided by shareholder shares. This essential information is present in the balance sheet of every company.
You may wonder why this ratio holds so much importance for investors. This is because it represents the leverage of the company and indicates its stability. Leverage defines how a business uses debt to finance its operations.
Moreover, it represents the shareholders' ability to repay any debts if the business were to hit a bumpy stretch. You may, however, want to note that the debt to equity ratio varies across industries.
When a company is borrowing lesser debt than the funding provided by the shareholders, it will represent a lower debt to equity ratio. A higher figure, on the other end, will signify that the company is under more debt. It will flag off the lenders who are considering investing in a company as it also indicates a high level of risk.
When a company is not making enough profits, it will still have to repay its loans. If the business owners cannot make sales as expected, the company go bankrupt.
Although a high debt to equity ratio may seem alarming at first glance, it is not always so. It shows that a company has been able to fulfill its debt obligations. Moreover, it could also indicate that the business has the leverage to give returns to its shareholders.
When a business has more debt, it means its equity account is lower. As a result, the return on equity is higher. Lastly, debt costs are generally lower than equity costs.
When shareholders invest in a company, they take on more risks. Due to this, they expect and demand higher returns.
A higher debt to equity ratio reduces the weighted average capital costs (WACC) for your company.
By now, you would have understood that the D/E ratio represents how your business has raised capital for its operations. As the owner of a small business, you must keep a tab on this figure when applying for a new loan.
While there is no right or a wrong number for the debt to equity ratio, a lot will depend upon the industry you function in. To play it safe, you may want to keep it between 1.0 and 2.0. However, other factors will also come into play when you approach a lender for capital.
A significantly high D/E ratio may indicate that your business is running on debt. It can alarm lenders that your business may crumble under losses and that it might default on repayments.
As a result, the lenders may increase interest rates, which is never good news for small business owners.
D/E ratio represents to what extent a business is using its assets for its debt. While it could be a good sign that the company has been utilizing funds to fuel its growth, it is not always so. As a company uses more funds, there is also a chance of higher income.
In the end, it comes down to the income that the business is generating vis-a-vis the cost of debt. If the interest rates are too high, you could be directing most of your income towards repaying the debt. In this scenario, the business could hardly be making any profits.
When the debt to equity ratio is closer to zero, it means that the business is not utilizing the funds available to expand its operations. This could indicate to the investors that the company is not realizing its full potential or value.
As the owner of a small business planning to go big, you may want to know the other uses of the D/E ratio in the world of finance. It is, particularly, a crucial value for companies with stocks.
Lenders also use it to calculate the levered beta, which defines the risk associated with the company's performance vis-a-vis the market volatility. A value of levered beta greater than 1 or lesser than -1 indicates it has greater volatility than the market.
It then becomes a crucial factor in choosing between new debt and new equity when raising funds. Taking new debt may increase the risk but helps maintain faith in the business. Equity financing, on the other hand, means giving up ownership.
As a business owner of a small business, the D/E ratio is essential to understand your business' health. It becomes all the more important when you are considering the option of financing your business. Although a high debt to equity ratio is not always bad, you may want to keep a tab on it and keep it in a healthy zone.
Similarly, it is a crucial figure for investors as it gives them an idea of the risk associated with a business. They can compare it with the industry average to make a decision about investing in a company.
You may want to note that the long-term debt to equity ratio is different from the short-term value of this figure.
When you consider shareholders' equity, you will calculate it by deducting liabilities from the assets. However, using this formula for the long-term is not right as the payment of debt also needs to be included while calculating this ratio.
Short-term debt consists of liabilities that can be paid within a year's time. As the business has to clear it within a short period, they are not considered a risk. Long-term debt, on the other hand, consists of debt that will take more than a year to clear.
Consider this scenario where companies A and B both have the same D/E ratio. However, company A has $1 million in short-term debt and $50,000 in long-term debt. Company B, on the other hand, has $50,000 in short-term debt and $1 million in long-term debt.
In this case, investors will consider company A as riskier because it has higher short-term debt. This kind of debt gets renewed frequently, and the changing interest rates mean more volatility. When the interest rates are rising, long-term loans are better.
When you are running a business, you will have to revisit your finances from time to time to get a perspective on its financial health. As explained above, the debt to equity ratio calculator will come in handy when you want to apply for a fresh loan. With the information given above, you can calculate the D/E ratio for your business for more clarity.
However, as a business owner, you have other essential areas to look after. Moreover, when you decide to do it yourself, there are higher chances of missing out on some details for accurate calculation.
Using a D/E calculator can help you in such scenarios. They are developed by experts and will give you more accurate results within minutes.
Armed with the knowledge of the D/E ratio of your business, you can now enter a meeting with creditors more confidently. You will have more context and can influence them to make a decision in your favor. And Fincent can help you in this journey as you navigate through your company's bookkeeping needs.