01 June 2011
The debt to equity ratio measures the amount of money your company can safely borrow over a specific amount of time. To obtain your ratio, you will compare the total debt and divide it by the amount of the owner's equity. Debt and equity are accounted for differently and each have a different impact on earnings, cash flow, and taxes. The way your company uses their funds will affect the financing options and debt to equity ratio.
Debt is often considered a loan, line or credit, or a bond. Basically is it a promise to repay amounts of money borrowed over a specified amount of time with interest rate or other terms. Debt is considered a liability for a company and the payments made to interest are deductible business expenses. Your business finance is directly related to your debt since it is used as a way to attract lenders. Your possible lenders will look at your debt, credit score, and cash flow. A lender will not grant you money if they think you cannot repay the loan. Equity on the other hand differs from debt as it represents a permanent ownership in the stake of the company. If you are financing with equity, you are giving up a portion of your ownershipinterest in the company in exchange for cash. Equity investors are typically contributions from business associates, family, and friends. Equity financing is typically a long-term funding option that is not associated with a specific amount of time. Equity financing has a major downfall since you can lose total control of the company if your ownership investors pull out. Your business finance depends on the proper balance of debt and equity. If you have too much debt, you will overextend your ability to pay and this will be vulnerable to larger interest rates or penalties. However, too much equity will affect your business ratio if your ownership interest is exposed to outside control. All in all, your debt to equity ratio needs a proper mix. It will be determined on the type of business, its age, and some other factors. An acceptable debt to equity ratio is considered 1:2 or 1:1. Depending upon your industry, this ratio will vary. Newly formed companies typically have not established a credit history and will weigh towards equity. However, if you have had a negative cash flow in earlier years, again, you are at risk for bad equity and bad debt rates. You will need to negotiate proper terms with your lenders or investors that are suitable for your companies needs.
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