Debt to Equity Ratio and How To Keep It Stable in New Businesses
There are some aspects of the business which are absolutely important to understand whether you are an entrepreneur or an investor, whether you have a small startup or a big business. The debt to equity ratio is one of them.
I am sure you have heard about it many a time. This is one of those crucial financial indicators that investors always check before investing money in a project. So, the question is how exactly you would define the debt to equity ratio? How can the entrepreneur look at keeping it stable?
Back to basics first before getting into the details of how to keep the debt to equity ratio stable, it is important to understand what comprises of a stable debt/equity scenario. As an entrepreneur, it is also necessary to understand the key elements that go on to determine this crucial ratio for your company.
Understanding Debt to Equity Ratio
In very simple terms, debt to equity ratio is a measure of a company’s financial leverage.
This is that important ratio that clearly spells out the amount of capital that has been provided by the owners and the amount that lenders or any other investor has put in. Essentially, the debt amount is divided by the equity to arrive at this ratio.
This ratio then clearly identifies the startup or new business’ ability to repay its monetary obligation as well.
Say for example, if a particular company showcases more debt than capital/equity, the internal cash flow of the company is less than the funding provided by creditors.
Studies charting out the success and failure of various startups indicate that this is a dangerous trend. It clearly signals that despite the capital infusion, the company is unable to generate the revenue that is required and could spell trouble for the entrepreneur in the long run.
On the contrary, when the equity portion is higher than the debt amount, it is a clear green signal in terms of the health of the company’s finances. The assumption in this case that the entrepreneur is successful in generating a higher rate of revenue and able to rein in the debt amount.
Ideally, first-time entrepreneurs often get swayed away and try and look for additional creditors to pump in cash. This can be a rather tricky and dangerous situation as it raises two primary red flags. First and foremost, the business is trying to expand at a rate higher than its comfort zone and secondly it slows down asset growth as well.
One must remember that it is always a good idea for a startup to target growth at an affordable rate at the beginning. You must understand that your firm’s growth is closely tied to the asset growth, and so to the debt to equity ratio that you can bring about and vice versa.
The ideal condition is when asset grows in tandem with the overall growth of the company. This ensures that the overall expansion of the firm is in sync with the growth profile.
Stability Important For Sustained Growth
While it is never a Utopia and many a time entrepreneurs may have to take in larger debt to fund the company’s growth, it is not advisable for a sustained period. The fact is growth that is fueled by debt does tend to falter beyond a certain point of time and is a rather risky proposition if you are looking for meaningful and sustained growth of the company.
This is exactly why you would have seen in the early 90s close to the heels of the telecom boom came a major fall as well. These telecom companies expanded significantly on debt as they were confident of generating enough revenue to pay it off. However, this idea did not pan out as envisaged. The revenue generation was hardly in sync with the debt that was incurred.
As a result, these telecom companies had to restrict a lot of the expansion plan they envisaged going forward. The debt part of the debt to equity ratio might often lead to an unstable business condition if not checked in time.
Entrepreneurs need to make informed choices at all times. They must follow the balance sheet of the company in details and also take account of the various day to day expenses which could result in overall skew in the balance sheet. In this way, they will be abreast with the daily dealings and can decide better on how to line up their debt planning to be more in command.
Too much debt always makes the business foundation flounder and many a time when entrepreneurs fail or are fired from their companies is because of this reason. A case in point is the Housing.com debacle. Here the management not just committed a lot of money in debt but also spent the money without any account of the corresponding revenue that is being generated. What finally happened was the debt to equity ratio was skewed against growth.
Eyes On Equity Growth
The only way to deal with this uncertainty is to keep your focus on equity. It is important for organizations to ensure that their growth is measured by growth in equity more than debt. This will ensure that the pace of growth is always within affordable limits and the debt to equity ratio is never stretched unnecessarily. So even if you need to take debt, you are always mindful that the debt numbers do not spike up unnecessarily.
Equity growth also ensures that an entrepreneur can sustain growth bit by bit without rushing through with huge debt. The equity therefore in this case also acts as an insurance that the company does not grow at an unreasonable pace, especially if the debt is fueling that growth. Balancing debt and equity also means that as an entrepreneur you also start budgeting expenses and never move out of your comfort zone to accommodate expenses. The debt to equity ratio therefore also helps you improve financial discipline.
Debt to Equity Ratio: How Much Is Too Much?
As an experienced entrepreneur, you already understand how different sectors have varying levels of debt-equity requirement. What works for one sector might not be true about another. For example, the financial sector if you notice has a significantly larger debt to equity ratio compared to say perhaps technology.
So, question is how you would ascertain how much debt to equity ratio is ideal for your company? This is a question that also takes us to the fundamental question about how much leverage are you comfortable with? Apart from sectoral limitations or preferences, this is the other key factor that will play a decisive role.
What most investors would do is pay attention to the company’s historical debt to equity ratio and how the current number stands in comparison. The performance of the company thus far and the current performance will easily help decide if the there are any red flags. If the divide between the historic debt to equity ratio and the current number is too much, it invariably means there is a source of worry and corrective action is necessary.
While some capital-intensive sectors like services and utility do need a higher capital allocation and hence a higher debt, in general, it signals aggressive growth plans. It shows the entrepreneur might have been over ambitious in setting the growth targets and achieving them. If the revenue generation is at par, then this isn’t so much of a worry.
However, if that’s not the case, then sooner this divide is minimized, the better it would be for the company’s growth. This is also a key player in keeping earnings growth on track and reducing uncertainties from the company’s balance sheet.
Higher debt if not supported by higher earnings could often cause sustained problems for an enterprise.
Why Do You Need Debt to Equity Ratio?
Well that said, we need to address the most important factor, why do we need debt to equity ratio?
Well for starters the debt to equity ratio is the entrepreneur’s best tool to assess personal progress. Moreover, this is important because
- Investors always refer to the company’s debt to equity ratio and projected debt plans to assess the growth and financial health of the company
- For an entrepreneur looking for funds, the DE ratio is the best tool to showcase superior growth standards and appropriate eligibility for loans if needed.
- Earnings of the company are also severely depressed if the debt to equity ratio is skewed in favour of debt
- A stable debt to equity ratio showcases your company as a safe bet to potential lenders.
- An enterprise with stable DE also has lesser chances to falter and finds more opportunity to grow.
- A stable DE also highlights entrepreneur’s restraint and fiscal prudence
- In the long-run, a stable debt to equity ratio easily becomes the greatest tool to fuel expansion
- If the company gets listed, stable DE makes the stock more lucrative in the stock market and that can lead to further gains.
Is Equity Overload Always Advisable?
That brings us to the fundamental question that is debt always bad news for a company?
Actually no! Many market veterans will explain to you how the successful running of an enterprise has to be a happy marriage between debt and equity. While theoretically it could be projected that if you can generate enough revenue to pay off the debt, that’s ideal, in real life this is hardly the case. In fact, that’s not always desirable either.
Actually, debt does have some advantages too, especially in terms of fueling growth for a company. You can always look at deducting the interest you might be paying for your loans as a business expense. Creditors who simply loan you fund never have any say in your business dealings as long as you pay their installment and loan amount on time.
On the contrary, if you bring in an equity investor they would invariably have a say as well as a stake in your dreams. Just because they have paid the money they will also expect to be listened to and could often be a hindrance on your independence.
Therefore, as long as your fund requirement is within manageable limits and you are getting creditors willing to loan you the money, it is never a bad idea to opt for the loan instead of bringing in a fresh investor. In this way, you will be able to meet your funding requirement also and not hamper the company’s growth chart or your individuality either.
Creditors often give you comfortable window to pay off the loan as well. If you can negotiate well, you also get the chance to pay off at a pace that’s comfortable for you without inconveniencing anything. However, as an entrepreneur you need to be careful of the interest you are paying and how much you can afford to.
Therefore, it all boils down to one fundamental business basic:
As an entrepreneur, the only way you can maintain comfortable debt to equity ratio is through proper planning and financial discipline.
Let’s assume you are drawing up a plan to chart out your company’s 5-year growth plans. You will have many parameters like improving revenue growth, profit, expansion and many other factors. It is beneficial to also account for the potential debt requirement that you might have.
This prior planning will enable better calculation. You can easily calculate how much debt equity you would need at a certain period to maintain business stability. This will also help calculate how much debt payment you can afford without impacting cash flow.
This will no doubt help you identify the red flags well in advance. Based on your actual requirement you can then plan accordingly on ways to fashion and channelize your growth initiatives and overall forward plan. Many a time it so happens that you can easily reset the business stability by either deferring or advancing a certain expense or a certain project. Of course, you have to ensure you do not hamper future prospects in any manner.
The debt equity situation does not just help in maintaining stability but also proper cash flow in the company. This is because it will help you keep a check on the overall debt situation and the resultant payments. Therefore, a health DE is often the key to a successful business.
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It goes without saying that the debt to equity ratio is a very important measure of a company’s financial progress and stability. This number is self-explanatory in bringing out the proper business prospects of an enterprise It also acts as a signal to the entrepreneur to undertake course correction whenever require. This can easily help you in getting funding from investors very easily and undertake important expansion.
A healthy debt to equity ratio also acts as company’s progress report to correctly showcase a firm’s business excellence.