Debt/Equity Ratio
This is simply dividing your total debt amount by your total equity amount. Both lenders and investors will want to see this number to get an idea of how financially viable your firm is and where their investment stands in case your firm goes bankrupt, since debt holders get priority over equity-holders in recovering funds during bankruptcy.
You will most likely take on some debt in the early stages but make sure to monitor how “levered up” your firm is, compared to the rest of your industry. Bizstats.com offers an easy way to gut-check your debt-to-equity ratio against a list of industry benchmarks. Reading this list shows investment banking is among the more risk-seeking industries, with a ratio of 29, while the electrical equipment industry comes in at a conservative 0.7.
When to Use Debt Financing
As mentioned above, the lender will be seeking installment payments on his loan shortly after the money is lent. That means in order to begin making payments you will need cash. Even a thriving business can be short on cash if its money is tied up in equipment, or customers aren’t paying. When considering debt, ask yourself:
- Am I using this money to invest in fixed or variable costs? If you’re investing in fixed costs, such as a new piece of equipment, then you likely won’t see any cash returns from it in the near-term. If you need the money to invest in variable costs such as materials for the product you make or costs associated with each new client, than the debt investment should have associated cash inflow
- What are my customers like? Customers who consistently pay on time are critical to cash flow and the ability to repay debt. Learn the payment habits of your customers and consider incentives to get them to pay early. Also, check with associations and competitors to make sure your payment terms are in line with industry standards.
- Where am I in my business lifecycle? In the early stages of a firm, debt financing can be dangerous. You will likely be losing money at first, thus hurting your ability to make payments. Also, since your net income will be low, the tax advantages of debt will be minimal. As your business grows and matures, debt becomes a stronger option. The tax advantage will be greater, your cash flow will be more predictable, and the risk you face in bankruptcy decreases since you have been operating longer.