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techsuch May 9, 2021 0 Comments

A Refresher on Debt-to-Equity RatioWhen people hear “debt” they usually think of something to avoid — credit cardbills and high interests rates, maybe even bankruptcy. But when you’re runninga business, debt isn’t all bad. In fact, analysts and investors want companiesto use debt smartly to fund their businesses.That’s where the debt-to-equity ratio comes in. I talked with Joe Knight,author of the HBR TOOLS: Return on Investment and cofounder and owner ofwww.business-literacy.com, to learn more about this financial term and howit’s used by businesses, bankers, and investors.What is the debt-to-equity ratio?“It’s a simple measure of how much debt you use to run your business,”explains Knight. The ratio tells you, for every dollar you have of equity, howmuch debt you have. It’s one of a set of ratios called “leverage ratios” that“let you see how —and how extensively—a company uses debt,” he says.Don’t let the word “equity” throw you off. This ratio isn’t just used bypublicly traded corporations. “Every company has a debt-to-equity ratio,” saysKnight, and “any company that wants to borrow money or interact with investorsshould be paying attention to it.”How is it calculated?Figuring out your company’s debt-to-equity ratio is a straightforwardcalculation. You take your company’s total liabilities (what it owes others)and divide it by equity (this is the company’s book value or its assets minusits liabilities). Both of these numbers come from your company’s balancesheet. Here’s how the formula looks:Consider an example. If your small business owes $2,736 to debtors and has$2,457 in shareholder equity, the debt-to-equity ratio is:(Note that the ratio isn’t usually expressed as a percentage.)So, of course the question is: Is 1.11 a “good” number? “Some ratios you wantto be as high as possible, such as profit margins,” says Knight. “In thosecases higher is always better.” But with debt-to-equity, you want it to be ina reasonable range.In general, if your debt-to-equity ratio is too high, it’s a signal that yourcompany may be in financial distress and unable to pay your debtors. But ifit’s too low, it’s a sign that your company is over-relying on equity tofinance your business, which can be costly and inefficient. A very low debt-to-equity ratio puts a company at risk for a leveraged buyout, warns Knight.“Companies have two choices to fund their businesses,” explains Knight. “Youcan borrow money from lenders or get money from equity.” Interest rates onbusiness loans tend to come with a 2-4% interest rate (at least at themoment), and that interest is deductible on your company’s tax returns, makingit an attractive way to fund your business, especially when you compare it tothe returns that an investor might expect when he or she buys your stock thatshows up as equity on your balance sheet, which can be 10% or higher.So you want to strike a balance that’s appropriate for your industry. Knightgives a few rules of thumb. Technology-based businesses and those that do alot of R&D tend to have a ratio of 2 or below. Large manufacturing and stablepublicly traded companies have ratios between 2 and 5. “Any higher than 5 or 6and investors start to get nervous,” he explains. In banking and manyfinancial-based businesses, it’s not uncommon to see a ratio of 10 or even 20,but that’s unique to those industries.There are exceptions within industries as well. Take Apple or Google, both ofwhich had been sitting on a large amount of cash and had virtually no debt.Their ratios are likely to be well below 1, which for some investors is not agood thing. That’s partly why, says Knight, Apple started to get rid of cashand pay out dividends to shareholders and added debt to its balance sheet inthe last month or so.How do companies use it?The calculation is most often used by bankers or investors deciding whether togive your company money. It helps them understand how you’re paying for yourbusiness. They want to know, says Knight, “Does the company have the abilityto develop revenue, profit, and cash flow to cover expenses?”If the debt-to-equity ratio goes up, the perceived risk goes up. If you don’tmake your interest payments, the bank or lender can force you into bankruptcy.“Bankers, in particular, love the debt-to-equity ratio and use it inconjunction with other measures, like profitability and cash flow, to decidewhether to lend you money,” explains Knight. “They know from experience whatan appropriate ratio is for a company of a given size in a particularindustry.” Bankers, Knight says, also keep and look at ratios for all thecompanies they do business with. They may even put covenants in loan documentsthat say the borrowing company can’t exceed a certain number.The reality is that most managers likely don’t interact with this figure intheir day-to-day business. But, says Knight, it’s helpful to know what yourcompany’s ratio is and how it compares with your competitors. “It’s also ahandy gauge of how senior management is going to feel about taking on moredebt and and therefore whether you can propose a project that requires takingon more debt. A high ratio means they are likely to say no to raising morecash through borrowing,” he explains.It’s also important for managers to know how their work impacts the debt-to-equity ratio. “There are lots of things managers do day in and day out thataffect these ratios,” says Knight. How individuals manage accounts payable,cash flow, accounts receivable, and inventory — all of this has an effect oneither part of the equation.There’s one last situation where it can be helpful for an individual to lookat a company’s debt-to-equity ratio, says Knight. “If you’re looking for a newjob or employer, you should look at these ratios.” They will tell you howfinancially healthy a potential employer is, and therefore how long you mighthave a job.What mistakes do people make when using the debt-to-equity ratio?While there’s only one way to do the calculation — and it’s prettystraightforward— “there’s a lot of wiggle room in terms of what you include ineach of the inputs,” says Knight. What people include in “liabilities” willdiffer. For example, he says, “some financiers take non-interest bearing debtsuch as accounts payable and accrued liabilities out of the liability numberand others might look at short-term vs. long-term debt in comparison toequity.” So find out what exactly your company counts in its calculation.Knight says that it’s common for smaller businesses to shy away from debt andtherefore they tend to have very low debt-to-equity ratios. “Privatebusinesses tend to have lower debt-to-equity because one of the first thingsthe owner wants to do is get out of debt.” But that’s not always whatinvestors want, Knight cautions. In fact, small—and large­—business ownersshould be using debt because “it’s a more efficient way to grow the business.”Which brings us back to the notion of balance. Healthy companies use anappropriate mix of debt and equity to make their businesses tick.

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