Debt Vs Equity – Arriving at the Right Ratio
A regular assessment of debt vs equity is of paramount importance for all businesses. In the case of a small business venture, this assessment becomes imperative as it helps in your long-term financial decision-making. Read on to learn in greater detail about the components as well as debt and equity, and what Information they can convey when considered together.
What is Debt and Equity?
As the name suggests, debt is what your business owes to external creditors. It includes all debts/liabilities to outsiders, whether long term,short term or in the form of bonds, mortgages or bills. Equity, on the other hand is the funds that you have brought into your venture. Equity includes capital, accumulated profits, contingency funds and funds created to replace assets.
What is Debt-Equity ratio and how is it calculated?
The Debt-Equity ratio is the ratio between the external debt and the internal funds of your business. This is a measurement of how much suppliers, lenders, creditors and obligors have committed to the business versus what you as a proprietor/partner have committed. It is calculated as follows:
Debt-Equity Ratio = External Debt/Internal Funds
Ideal Ratio: A ratio of 1:1 is usually considered to be satisfactory. However, there is no rule of thumb or standard norm for all types of businesses. Theoretically, if the owner’s interests are greater than that of the creditors, the financial position is highly solvent.
• A ratio of less than 1:1 means:
- Owner’s equity is more than debt
- The owner is bearing more risk in the business than the external creditors
- The owner has a strong financial interest in the business
• A ratio of more than 1:1 means:
- Owner’s equity is less than debt
- The owner is bearing less risk in the business than the external creditors
- The external creditors have a strong financial interest in the business than the owner
Interpreting Deb-Equity Ratio: Since the debt-equity ratio indicates the proportionate claims of owners and the outsiders against the firm’s assets, its purpose is to get an idea of the cushion available to outsiders on the liquidation of the business. Often, the interpretation of the ratio depends upon the financial and business policy of the business concerned –
• The owners may want to do business with a large amount of an outsider’s funds. This way they run a lower risk on their investment and increase their earnings by paying a lower fixed rate of interest to outsiders.
• The outsider’s (creditors), on the other hand, want the owners to invest their share of proportionate investments. Finally, too much debt can put your business at risk and can indicate difficulty in meeting interest and principal repayments. While too little debt suggests that you are not taking advantage of opportunities and haven’t realised the full growth potential of your business.