Understanding Debt Equity and Knowing Your Company’s Financial Leverage
Financing your business usually takes more than the money in your bank account. Most business owners need outside capital to launch and maintain their assets (real estate, business technology, etc). Since it probably isn’t coming from your pocket, you need to know where it comes from.
As a result, understanding debt equity is crucial for any business owner. In this article, we look at debt and equity and how they affect your company’s financial health.
Debt and Equity to Raise Capital
Two of the main ways to raise capital are debt and equity. Debt is what you owe when you borrow money to cover everything you need to run your business. When you borrow money from banks, credit unions, or private lenders, you pay it back along with accrued interest. This is debt.
On the other hand, Equity represents ownership in an asset. In contrast to debt, using equity to finance a business usually involves selling shares of your business (such as stock or securities) to investors with the promise of returning their capital investments in increments. This equity makes them partial owners of your company.
The Debt/Equity Ratio
Understanding debt to equity ratio helps you know the health of your business’ finances. Simply put, the debt/equity ratio measures your company’s financial leverage. But what is leverage? Using debt to finance your business activities and purchase assets is leverage. If debt is your primary means of financing, your business is ‘highly leveraged.’ In this situation, your debt to equity ratio is usually higher.
In general, this debt equity ratio represents the debt and equity used to finance your company’s assets. Below is a simple formula:
Debt to Equity Ratio = Total Liabilities / Total Shareholders’ Equity
Total Liabilities are all of your company’s debt — short-term, long-term debt, and other financial liabilities. Shareholder’s Equity is your company’s total assets minus its total liabilities.
For example if your Total Liabilities were $100,000 and your Total Shareholder’s Equity was only $20,000, your debt/equity ratio would be 5 ($100,000/$20,000).
However, if your Total Liabilities were $50,000 and your Total Shareholder’s Equity was $100,000, your debt/equity ratio would be 0.5 ($50,000/$100,000).
By understanding your debt to equity ratio, you have a good handle on how your business is doing financially.
Using this Ratio
Understanding the debt/equity ratio is important for you the business owner. Overall, your debt/equity ratio is also a good indicator of your business’ financial standing. When the ratio rises, it means your debts are also rising.
At the same time, understanding how potential investors and lenders’ view your debt/equity ratio is equally important. To investors and lenders, a highly leveraged business is not attractive. In general, a lower debt/equity ratio shows your business is less of a risk for lenders and investors. As well, a higher debt/equity ratio shows your business relies more on lenders and debt. It also marks your business as higher risk for lenders and investors.
For example, if your debt/equity ratio is 1.00, half of your assets are debt-financed and the other half are financed by shareholder’s equity. When your debt/equity ratio is greater than 1.00, it means you’ve used more debt than equity. In contrast, a value lower than 1.00 is the opposite (greater equity and less debt).
Understanding Debt and Equity
By getting a handle on the debt/equity concept, you can better position your business when approaching lenders and investors in the future.