As we continue our series reviewing the balance sheet, the next important ratio to discuss is your company’s debt to equity ratio. This ratio is important as financial institutions review this ratio to determine how risky/over-leveraged your company is. In addition, should you decide to sell your business one day, this is the ratio buyers will look at to determine if it is a fair purchase price.
Let’s clarify some terms:
Debt is the total amount of what is owed by the company. This includes loans, accounts payable, anything that is a debt that needs to be paid back.
Equity or stockholder’s equity is simply the difference between the sum of the company’s assets and sum of the company’s liabilities.
To calculate the debt to equity ratio simply divide the company’s total debt by the company’s total equity.
Debt to Equity Ratio = Total Debt / Total Equity
A strong debt to equity is 2.5 to 1 or better, the lesser the ratio the stronger the company. A high debt to equity ratio means the company is over-leveraged, they may have taken on too much debt and are considered a risky investment. They may not qualify for future financing or they may end up paying a significantly higher cost to securing financing.
For example: If a company has $500,000 in total debt and $100,000 in equity then their ratio would be 5 to 1. They have 5 times as much debt as equity in the company. Since this is over 2.5 to 1 this would be considered a higher risk company.
There are some cases where a company owner is taking a draw personally from the company’s equity. Put simply, if an owner decides to take $100,000 distribution from the company then the equity portion would be reduced by $100,000. We have reviewed financial statements where the owner has taken distributions and the company on paper seems to have a much worse debt to equity ratio than what appears. In this case the personal tax returns need to be factored in as well.
For example: A recent corporation that we reviewed had $2,000,000 in liabilities and $110,000 in stockholder’s equity. When looking at a ratio of almost 20 to 1 the company would appear to be extremely over-leveraged, high risk, with almost 20 times the debt compared to the company’s equity. However, the owner did take a $400,000 distribution that year, which when factored back in, would make the equity portion $510,000 and a better than 4 to 1 ratio.
Not all financial institutions look in detail at what constitutes a strong business. As a business owner, when you are looking to grow your business make sure that you not only understand your company’s basic ratios but also work with a funding partner that can structure terms that help you maximize the financial strength of your company. Anyone you work with whether it be financing real estate or equipment should be consulting with you on your specific situation vs just trying to book more business for themselves.