When you are looking for getting financing for your business, there are many financial factors that lenders consider when determining to approve or deny your application. These include your personal credit and debt coverage, personal debt and business debt usage, business revenue trend, and more. Another important factor they look at is your debt-to-equity ratio. Today we will discuss what your debt-to-equity ratio is and how to calculate it so you can ensure you get the best rate and terms when applying for a business loan.
The debt-to-equity ratio shows how much debt and equity a business uses to finance its operations. This ratio tells a lender or investor how reliant you are on debt financing. When your ratio is low, it means that your business is more stable. A high ratio indicates that the business is getting more of its financing by borrowing money which is risky because the debt levels are too high.
How to Calculate Debt-to-Equity
The debt-to-equity ratio is your total liabilities divided by your total amount of shareholders’ equity. This shows a company’s debt as a percentage of its shareholders equity. A low ratio of 1.0 or lower, this means the firm is less risky than those who have a higher ratio. Firms that have a ratio of 1.0 or higher, use more debt in financing their operations than equity. A ratio that is less than 1.0 means they use more equity than debt. However, an ideal debt-to-equity ratio depends on the type of industry because some industries use more debt financing then others. Industries such as financial and manufacturing industries are capital-intensive and often have higher ratios greater than 2.
A high debt-to-equity ratio indicates a business uses debt to finance its growth. Industries that are more capital intensive invest large amounts of money in operations and assets, so their ratio is high. A low debt-to-equity ratio means the business has not relied on borrowing to finance its operations.
Some companies may have a negative debt-to-equity ratio which means the business has interest rates on its debts that are greater than the return on investment. A negative debt-to-equity ratio can also mean that the company has a negative net worth. Lenders and investors see a negative ratio as a company that is financially unstable. Other reasons for why a company can have a negative debt-to-equity ratio is that they are making large dividend payments that exceed shareholder’s equity or are expensing intangible assets that exceed the shareholder equity values.
Another important factor that lenders consider is what kind of debt you have. They will want to know if it is a long-term loan or short-term loan and how much of an impact interest rate fluctuation have on the debt. This will help lenders come to their decision of approving or denying your application.
Debt must be repaid to the lender unlike equity financing. Debt can be more expensive and those companies who have a large amount of debt might not be able to make the monthly payments.
What to Do If You Have a High Ratio
If you determined that your debt-to-equity ratio is high for your industry, there are loans available if your business profile is not what lenders are looking for.
You can get a business line of credit in which you can have a revolving amount of cash that you use at your leisure anytime. With a line of credit you can qualify up to $500,000 but rates can be high. To qualify for this loan you will need a credit score of at least 560. You need to be around for at least 6 months and have an annual business revenue of $50,000 or higher.
Another loan you can consider is a merchant cash advance. With this loan, you are borrowing against your business’s future earnings. Interest rates start at 18% and you can qualify up to $200,000.
A high debt-ratio is not always bad because it shows a firm can easy service its debt obligations and use the leverage to increase equity returns.
Lenders and investors look at a company’s debt-to-equity ratio when deciding whether to approve or deny your application for financing. Whether you have a high ratio or a low ratio, there are various options on the market that will meet your business needs.