Cold morning light showers your back as you contemplate whether to file for bankruptcy or to continue believing in your startup’s mission. As your mind wanders, you think back to when you first set out to take on the market, what went so wrong, and what you could have done differently.
The risk of going belly-up should strike fear into any startup founder as the Small Business Administration estimates that: “About two-thirds of businesses with employees survive at least 2 years and about half survive at least 5 years.” Furthermore, a poll by Gallup reveals that about one-third of small business owners are uncomfortable with the amount of debt their business is in.
To some degree, debt is a measure of the risk that a business is taking on. The amount of debt in relation to a business’ equity and credit determines whether or not a loan is excessive.
The relationship between debt and risk
By successfully relating debt to risk, you’ll understand the why and when of taking on debt for a business. Business owners should understand debt as a function of risk.
The debt-to-equity ratio is in part a statistical way for business owners to conceptualize the nature of debt through the amount of financial leverage it possesses. In simpler terms, the debt-to-equity ratio quantifies what you using against what you have. To avoid excessive debt, you should generally aim to keep your business’ debt-to-equity ratio below 2.
The math behind excessive debt
So how does the debt-to-equity ratio connect the concepts of debt and risk? The value of your equity is essentially a measure of how the market and society values your business currently, while the amount of debt you’re taking on might be thought of as your own advance on how much your business is worth. Knowing the ratio between the two will help you understand just how big of a risk you are taking – this is equivalent to the excessiveness of your debt.
Let’s say I own a lemonade stand that has shareholder equity worth $100. If I take out a loan of $50, it means that I have a low debt-to-equity ratio (0.5). Conversely, if I take out $200, it means I have a high debt-to-equity ratio (2.0). Tack the word “million” at the end of these values and throw in some very complicated math and you’ll have a ballpark representation of how a large company sees this issue.
Why is this information useful? Depending on the specific nature of your business, a low debt-to-equity ratio may reveal to you that you’re not taking advantage of the profits your business is making by leveraging your financial power. Meanwhile, a high debt-to-equity ratio may imply that your business is overextended and won’t be able to generate enough cash to compensate for the value of its debts and interest.
For most purposes, if your business has a debt-to-equity ratio of 2, then taking on even more debt and pushing that ratio to 2.5 or 3 would be considered “excessive” and you would know not to do that from the calculation. At a debt-to-equity ratio of 2, your business receives two-thirds of financing from loans and only one-third from shareholders. The fact that your business derives 66 percent of its value from loans makes its financial basis risky.
Minimizing risk gives your business more financial power
Having extra financial leverage can save your company from bankruptcy when you are reacting to a situation where your company has choked itself dry of profits due to improperly planned cash flow. Framing your business as low-risk may save it from a fate where it collapses under itself due to underinvestment (i.e. investing too little into your business may have destroyed its growth).
If people perceive the risk of lending money to you to be low, then you are able to leverage more financial power at a proportional rate. We’ve all heard that the United States’ national debt is astronomical. It’s currently sitting at $19.8 trillion, an incomprehensibly large number for most of us.
Ask yourself why countries and the world, in general, allow the United States to take on a sum $19.8 trillion in debt but not yourself as an individual. Compare it to the combined value of what all your best friends would comfortably lend you. Maybe a few thousand if they’re really feeling generous and even that’s probably stretching it.
It seems like a stupid question and if you’ve answered something related to the size or reliability of the United States, then you’ve explained why minimizing risk gives your business more financial power. Because people know that the chance of the United States defaulting on its loans is near zero, they’re comfortable with making huge loans to the country. Unfortunately, the chance of you or your business “defaulting” or not paying back your loans is not zero, so the loans you can get reflect this.
Of course, the risk associated with making your business a loan has already been quantified in an everyday measure – your business credit score. Your business’ credit score is a measure of the risk associated with lending your business money based on your business’ transaction history. It plays a similar role to your personal credit score in determining the type and quality of loans you’ll receive.