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Debt versus equity
You can finance the start-up and growth of your business from three sources: retained earnings, debt, and equity. Retained earnings are the cumulative profits your business has earned, less any dividends or draws paid to the business owner.
When you forecast sales and profits, you also tend to forecast cash flows. Cash flows consist of the cash inflows and outflows of your business. Accurately predicting cash flows—making sales, collecting on accounts receivable, etc.—is a difficult task. A sales deal may be delayed, or a customer may fall behind in its payments to your business.
The uncertainty of predicting cash flows is just one reason why it is often necessary to depend on external debt or equity to pay for some of the growth and operations of your business.
How much debt you use as a percentage of your firm's equity is called your debt-equity ratio. (The sum of debt and equity is your total capital.) A high debt-equity ratio indicates more leverage. The more leverage, the more difficulty your business will face in servicing its debt. Since debt-to-equity ratios vary from industry to industry, it may be a good idea to target a debt-equity ratio that is comparable to those of your competitors.
Debt-equity ratio depends, in part, on the industry in which your business operates. If your business is a restaurant or other cash-rich business, you may generate enough in cash flows to pay all your bills and avoid a high debt-equity ratio. For example, if you have yearly sales of $250,000 and collect 90% in cash, your cash-flow shortage is only $25,000.
However, if your business collects only 60% of $250,000 of sales in cash, it is more likely to need additional financing from debt or equity. Similarly, if your business doesn't generate much revenue for the first year or two, you are more likely to rely on debt and equity financing from external sources. For example, if you forecast $50,000 in cash flows in the first year of business and need $250,000 in capital, you will need to raise 80% of your total cash requirements.
A prospective lender may often only consider lending funds if the debt-equity ratio of your business is below a critical level. If you are unable or unwilling to raise equity from an outside investor, the equity in your business will help you to obtain debt financing.
While retained earnings are the cumulative equity from an existing and profitable business, a fledgling business is unlikely to have built up any. As a result, the business owner will likely have to contribute his or her personal equity.
Your firm's capital structure—how much in debt it decides to use in relation to how much equity—determines its debt-equity ratio. Capital structure also determines the cost of capital for financing your business. If your cost of equity financing is cheaper than debt, your target debt-equity ratio will be lower (larger denominator). If your cost of debt financing is cheaper than equity, your target debt-equity ratio will be higher (larger numerator).
The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax adviser.
Next Topic: Financial leverage
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