Debt to Net Worth – The Pros and Cons of Leverage

Debt to Net Worth – The Pros and Cons of Leverage

Be Sociable, Share! TweetAn old bank customer of mine called me the other day. He was wondering whether he should borrow to finance an impending, but temporary, shortfall in cash flow later in the year. He had sufficient personal cash to inject to get over the hump. I advised him that he was better off in this case using leverage rather than an equity injection. Why? Simply put, leveraging the bank’s balance sheet to fund the temporary shortfall left him with cash for opportunistic inventory purchases, which could increase profits dramatically. Using all available cash removed that option. This is our second article on financial statement ratios and what they mean. The Debt to Net Worth Ratio Debt to Net Worth (also known as Debt to Equity) is the ratio of total liabilities on the balance sheet to owner equity. A company that had $500,000 of liabilities to $100,000 of owner equity would have a Debt to Net Worth ratio of 5/1. For every dollar the owner has in equity, the company owes five dollars to creditors. That would be considered highly leveraged. In some start ups, where the owner is injecting only 10% equity and the bank is financing the rest of the start up capital requirements (nearly always with an SBA guaranty) Debt to Net Worth can be 10/1. Most banks subtract intangible items like goodwill from the owner equity to get a ratio called Debt to Tangible Net Worth. What The Debt to Net Worth Ratio Means It is generally assumed that as companies mature, their Debt to Net Worth will improve over time. A company that...
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