What is the Debt to Equity ratio and why is it important to a small business owner like Felix Gonzalez?

The Debt to Equity ratio is a key ratio that is most widely used in the analysis of financial statements for a small business like Central Plumbing & Heating Inc. It measures the amount of protection the creditors of the small business have when compared to the amount of equity invested by the owners of the small business. It also shows how much each party has vested in the small business. This is a very significant ratio looked at by potential investors like venture capital firms who want to see not only if there is a return on their capital but if there will ever will be a return of their capital!

The way to measure the Debt to Equity ratio is to divide the Total Liabilities or debt of the small business by the Total Equity. Thus this gives us the total leverage being employed by a small business. As a general rule the lower the Debt to Equity Ratio the better it is for a small business.

A low Debt to Equity ratio indicates that the business is not very leveraged and has not borrowed too much when compared to the amount invested by the business owners in the business. A relatively higher Debt to Equity Ratio on the other hand indicates that the business is carrying a lot of debt for every dollar invested in the business by the business owners.

Is an increasing Debt to Equity ratio an indicator of future problems for a small business owner like Felix Gonzalez?

Yes - for the most part. An increasing Debt to Equity Ratio indicates that either of the two things could be happening - either the total debt outstanding by the small business is increasing and / or the amount of equity invested by the shareholders is declining. In both the cases further analysis will have to be conducted by the small business owner to understand why the Debt to Equity Ratio is increasing.

In the event further analysis by a small business owner like Felix Gonzalez shows that the Debt to Equity ratio is increasing due to an increase in the total debt outstanding it could mean that the small business has had to draw down on its existing business loans and lines to expand its operations resulting in a higher total debt outstanding. It could also indicate that the business has taken on more debt to sustain or expand - in either cases the lenders to the small business will now have a larger stake in the business than they did before in proportion to the amount of equity invested by a small business owner like Felix Gonzalez.

It could also be determined in the analysis by Felix Gonzalez that the Debt to Equity ratio has increased due to a decrease in the amount of shareholders equity due to a withdrawal of the equity from the business by business owners. This could be a planned withdrawal or distribution of equity or an unplanned withdrawal of equity. In the event the small business owner has never withdrawn any equity from the small business since inception and is finally looking to take on a small amount of debt and take some of his own invested capital out of the business, it may not be a bad thing at all.

What many lenders and partners may not like is that right after they have made an investment or loan into a small business like Central Plumbing & Heating Inc. based in Mecklenburg County ,North Carolina, they find that the owners of the small business have gone and withdrawn a large chunk of equity from the business - basically the business owners are using the lenders or partners money to cash out of their own business.

In start up companies, lenders and potential partners do not like to see withdrawals of equity at an early stage and you would be smart not to have this is the financial projections for the first 3 years of a startup. Folks looking to lend and partner up with you want to see that you are a 100% vested in your business and are not looking to cash out with their capital.

Does having a lower Debt to Equity ratio give a small business like Central Plumbing & Heating Inc. an advantage over its competitors?

Yes - for the most part. Having a lower Debt to Equity ratio for a small business like Central Plumbing & Heating Inc. indicates that it is employing lesser leverage than the competition and as such will be able to handle the cost of covering the debt much better than the competition which may be leveraged to the hilt and not able to withstand any slowdown in its business.

In addition having a lower relative Debt to Equity ratio for a small business like Central Plumbing & Heating Inc. will give it the ability to raise capital with relatively more ease than competitive businesses that don't have a low leverage. When lenders are looking to make business loans they want to see how much equity the small business owners and partners have in the firm when compared to the amount of money they are asking for - one of the most common ratios that they look at is the Debt to Equity ratio before and after the business loan.

Thus if lenders look more favorably at small businesses with lower debt to equity ratios, for sure those smaller businesses wil have an advantage raising capital from lenders and potential partners than businesses employing more leverage.

A point must be made however about small businesses that choose to employ no leverage at all - of course these businesses will have the lower Debt to Equity ratios than their competitors. However they will also have a disadvantage in that by choosing not to employ any leverage and take on no debt at all, they are also running the risk of the owners having to come up with equity for every things thus making the expansion of the business a much slower affair.

As is well known, growing organically using only equity takes a lot longer than expanding using a combination of your own capital and somebody else's money. While we don't recommend that small businesses take on too much debt and a balance has to be struck as always with every business decision - having access to business loans and lines of credit is always a good things. This is how a small business owner like Felix Gonzalez can take advantage of opportunities like buying up a competitors assets on the cheap thereby gaining a tremendous advantage.

Quick Links:

1. Go to the Corresponding Template section for this industry.
2. Go to the Corresponding Business Plan section for this industry.