Business Loan: The Debt to Equity Ratio
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Home Page > Finance > Loans > Business Loan: The Debt to Equity Ratio
Business Loan: The Debt to Equity Ratio
Posted: Jan 11, 2011 |Comments: 0
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Business financing or obtaining a needed business loan is not really rocket science on the part of banks, non-bank lenders or financial institutions. It is just a matter of realizing a return for the risks taken given their cost of money.
Sounds easy enough – but, what does it really mean. Banks and other lenders just want to get repaid and earn a reasonable profit. Just like you expect in your business – you want customers to pay for your goods and services. Lenders are no different and the principles are the same.
Banks have to get their inventory (cash to lend) from either depositors or investors (both of which add costs to the lender) – very similar to a manufacturer purchasing raw materials. However, when the manufacturer sells its finished product – the company expects to get paid (to cover both costs and profits) in a relatively short period (60 to 90 days).
Banks / lenders on the other hand could wait years (even decades for large commercial or real estate loans) before recouping their principle (costs) let alone their profit (interest and fees). Thus, banks and other lenders must work very hard to ensure the safety and soundness of the company requesting a loan (borrower) and to reasonably ensure themselves that they will be repaid.
Most lenders (banks and non-bank lenders) typically look for two items when assessing a business loan prospect. Is the business willing to repay the loan based on how it or its owner have repaid debts in the past (credit report) and can it repay; meaning does it have the cash flow (inside the business) to make the monthly payments and will this cash flow continue over the life of the loan.
But, as stated, while this is not rocket science – banks and other lenders tend to get quickly caught up in long-winded calculations in determining a borrower’s ability and willingness to repay. One such calculation is a business’s Debt-to-Equity ratio (sometimes called the Debt-to-Worth ratio).
David A. Duryee in his book “The Business Owners Guide to Achieving Financial Succe$$”, states about the debt-to-equity ratio “It is a basic financial principle that the more you rely on debt verse equity to finance your business, the more risk you face. Therefore, the higher the debt to equity ratio, the less safe your business.”
Here, equity could mean either outside equity injected into the company by investors, founders or owners, equity generated through the business from sustained profitable operations, or both.
In plain English, this has to do with the assets of the business. Most businesses have to purchase or generate some type of assets over time; be it equipment or property, intangibles or financial assets like cash and equivalents or accounts receivables.
Thus, if your business has financed these assets with a lot of debt – should your business not be able to pay, there would be many other debt holders in line to liquidate those assets to try and recoup their loses – making your new debt holder (the bank or lender) lower on the list and in a worse position to get repaid should your business default.
To clear this up a bit more, as Mr. Duryee states, think about this ratio in dollars; “If you apply a dollar sign to this ratio, a debt to equity ratio of 2.25 would mean that there is $2.25 in liabilities for every $1.00 of equity, or that creditors (banks and lenders) have a little over twice as much invested in the business as does the owners.”
To calculate your business’s Debt-to-Equity ratio, simply divide your total liabilities (both short-term and long-term) by equity – or visit the financial ratio calculator at Business Money Today and look for the Safety Ratio section.
Most bankers or lenders will not even consider a loan prospect with a debt to equity ratio over 3.00 times – but, some equipment or capital intensive industries may have higher ratio standards.
Know this, according to Kate Lister in an article with Entrepreneur magazine; the debt to worth ratio will show a lender how heavily financed your business is with other people’s money (not including investors’) and if your ratio is high, your business will be considered high risk or un-lendable.
To combat this, work to ensure your business’s debt to equity ratio is as low as possible should your business seek outside debt financing in the near term. You can either increase the amount of equity in your business (take on more investors, generate and retain more net profits, or infuse more in owners’ equity) or work to reduce your overall liabilities (paying off suppliers, other debtors or reducing any outstanding liability on the business’s balance sheet).
Lastly, not only will lenders review your current debt to equity ratio, but will attempt to measure it over time (that is why most bankers and/or lenders ask for three or more years of tax returns or financial statements). They not only want to see a low ratio today, but want to see this ratio trending downward over time. As your business’s debt to equity ratio trends down, the safer your business becomes when seeking a business loan.
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Joseph Lizio holds a MBA in Finance and Entrepreneurship, is the founder of Business Money Today, has a strong commercial lending background and is regarded as an expert in business and finance.
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