An 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 does not improve their Debt to Net Worth ratio over time is normally distributing almost all profits, or adding debt consistently to finance sales growth.
While a strong debt to net worth is always desirable, any small business with a ratio of 1/1 or better would be considered strong, there are times when adding leverage can make a great deal of sense.
Take the case of a computer software company that enjoys gross profit margins of better than 50%, and net profit margin of 15%. An opportunity arises to enter a new market, however the cost of marketing, building a sales force, and support functions around the new market are considerable. Using bank debt with an interest rate of, say, 7% is very attractive. The company essentially gets pays 7% to get 15% additional profits.
What to Watch Out For
When leverage becomes excessive however, the company places itself in danger. A strong Debt to Net Worth is one test of how well a company can weather long term adversity. A company with a strong Debt to Net Worth that must adapt to a change in the market over a long period of time is more likely to be able to draw on its balance sheet to get through the issue. A strong Debt to Net Worth can allow a company to survive negative changes in cash flow and profits, sometimes for years.
In the last decade this country saw many using high leverage in the real estate market attempt to get rich by purchasing real estate with extreme leverage and hoping the rise in real estate prices would result in huge profits.
Someone would inject $100,000 to purchase a $1,000,000 house or building. The bank would finance 90%. If the price rose 20% the investor made $200,000 profit off their initial $100,000 investment. The bank assumed 90% of the risk for a return on their loan of around 5-7%. For a while both bank and investor prospered. However, the same leverage that produced huge profits created huge losses when real estate prices fell. It only took a 10% drop in prices for the 10% investor to have their equity wiped out. Further drops in price produced losses for the bank.
Debt to Net Worth is one of the most important test of a company’s fiscal health. It can demonstrate the discipline and reward of competent management, but can also be a sign of potential problems. Knowing when and why to use leverage, and having the discipline not to abuse it, is key to growing your business profitably.
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