I have read through the Book of Proverbs a couple of times over the past 12 months. One proverb that always sticks with me is from Proverbs 22:7, “The rich ruleth over the poor, and the borrower is servant to the lender.” While this proverb has meaningful applications for individuals, I want to discuss the application for small businesses.
Business owners generally use debt as a way to grow their business at a faster pace than they are able to grow using only the cash generated by operations. Oftentimes, business owners will seek to rapidly grow their business. They forget about economic downturns, which always happen sooner or later. Businesses with high levels of debt generally have more trouble surviving than companies with low levels of debt.
Looking at your balance sheet
There are two sides to every balance sheet. On one side is the assets of your business. Every small business has assets, even if it is just cash. On the other side of the balance sheet are the claims on the assets of the business. These claims are separated into liabilities and equity.
Liabilities are amounts that you owe to others outside of your business. Simply put, these are your debts. These amounts could include payroll liabilities, accounts payable, and credit card debt. These debts are not usually secured by the assets of the business. Liabilities may also include notes payable and leases payable. These debts are usually incurred as a means to buy assets, and will be secured by those assets.
Equity represents the part of your business that you actually own. Total assets, less the liabilities owed by the business, equals owner’s equity. Except that equity is just an estimate. While most of your typical business liabilities can be easily measured, the equity portion of the balance sheet is what is left over. Its accuracy depends on how closely your asset values on your balance sheet reflects your assets’ true market values.
The thing about creditors is this: they expect to get paid. So, if your business were to close tomorrow, you would need to pay your creditors first. Whatever is left belongs to the owners of the business.
Looking at your debt to equity ratio
The relationship of how much is owed to creditors as compared to the equity of the business owners can be expressed in the debt to equity ratio. An equal amount of debt and equity would be represented by a ratio of 1. The higher the ratio, the more debt the business has. Knowing your debt to equity ratio is great. Knowing what to do with that information is something else entirely.
To know how to interpret this information for your business, it helps to compare your ratio with other businesses in your industry. Knowing how you compare to other companies in your industry is one way to see if your business is maintaining unhealthy levels of debt. Some industries rely on debt much more than others.
Example. Joe is a crane operator. He wants to start his own business. To do so, Joe needs a crane. But Joe is having trouble saving enough money to purchase a crane. If Joe wants to start his business, he will have to either lease a crane or borrow funds to purchase a crane. Joe purchases a crane for $500,000. He borrows $450,000 from a finance company and pays $50,000 down with funds that he has saved.
In the above example, Joe must incur debt to start his business. Assuming that the purchase of the crane is his first business transaction, then his debt to equity ratio is 9 ($450,000 debt ÷ $50,000 equity). This is an extremely high figure for any industry.
How much debt is too much debt?
Business owners should watch their debt to equity ratio over time. While your current level of debt may be considered normal in your industry, you may have cause for concern if your ratio has been consistently increasing over time. A rapidly increasing debt to equity ratio can be the result of declining profits as much as from increasing debts. If your debts are increasing, you need to know why. Are you purchasing assets or financing business losses with a line of credit?
Remember the proverb. Incurring more debt will ultimately give you less control over your business. Lenders will want to monitor your financial results by regularly reviewing your financial statements. Sometimes, loans will contain covenants requiring businesses to maintain certain financial ratios. The last thing that you want as a business owner is for the bank to call in your loans.