In this issue:
When you buy a home, you’re expected to make a down payment out of your own pocket – typically 20% of the cost of the home. The banks want you to have some skin in the game. The skin is called “equity”. As you build additional equity in your home, banks are willing to let you “leverage” that new equity and take out additional debt on the home.
The same holds true for your business, and in about the same ratio of “debt to equity” – if you put 20% down on a home, the debt portion is 4X the equity portion. If the equity in your business is about 20% of the total debt, you’ve got an acceptable amount of leverage, represented by a debt:equity ratio of 4:1.
If debt is greater than 4X equity, creditors will be less willing to write new loans to the business. At debt:equity of 10:1, your business is considered highly leveraged and you’re unlikely to attract any new financing. Any additional debt (or reduction of equity) puts your company on shaky financial ground, with too much dependence on customer deposits to make payroll or get bills paid.
Where Equity Comes From
Equity is “your money”. It’s the money you invest in the business, in the first place. More significantly, it’s the money you accumulate in the business over time. We call these “retained earnings” – profits earned, less taxes paid, that are left in the business.
Customer deposits are not “your money”, they are a loan from your customer. Properly accounted for, customer deposits are classified as debt, until you do the work prepaid by the deposit. Because of this, debt goes up when you receive customer pre-payments. Only when you have actually performed the associated work – and earned a profit on that work – does debt decline and equity increase.
Now, you can grow equity via further investments by company owners. But the real key is to make money, and keep enough of it in the business to maintain a healthy equity position.
Get to Know Your Balance Sheet!
Towards the bottom of your Balance Sheet is a line titled Total Liabilities. This is your total debt, and includes all payables, credit card balances, accrued taxes and expenses, customer deposits, and loans. A few lines down Total Equity is quantified. It’s simple math to calculate your debt:equity ratio.
Unless, that is, your equity is $0 or less. Then, you’ve got an incalculable ratio – and a very scary and risky financial condition.
You should monitor your debt and equity as closely as you monitor your revenues and profits. We covered this in last week’s First Friday webinar. If you’d like to learn more, you can download the 30-minute webinar recording at www.bi4ci.com/resource-library.