How To Balance Debt And Equity As A Small Business

From a financial perspective, a business is made up of two forms of capital — debt and equity. Most business owners and entrepreneurs prefer one form of funding over the other, since they each have different advantages and disadvantages. However, for most businesses the pragmatic option is a combination of debt and equity.

When you first start a business, you need to fund it with your own money, the money from investors, help from friends and family, or one of the many small business loans on offer. Picking the perfect ratio of debt-to-equity will bolster your balance sheet and help you sustain the business profitably over the long haul. Based on valuation expert Aswath Damodaran’s in-depth analysis, here’s how you can strike the perfect balance:

Understand the Ratio

There’s a number of reasons small business owners need to pay attention to their capital structure. The debt-to-equity ratio is an important metric for investors and banks who may consider funding the venture. The level of debt in a company is also an important indicator of the venture’s risk. Too much debt could sink a business and push it toward bankruptcy. Too little debt will probably prevent the business from growing and expanding at a reasonable pace. For most business leaders, there are a number of ways to decide how much to borrow.

Reduce Cost of Capital

The weighted average cost of capital or WACC is the discount rate applied to the future cash flows from your venture to value it in the present. In other words, the lower the cost of capital, the higher the value of your business. Debt funding has certain tax advantages, which means a higher debt-to-equity ratio will reduce the cost of capital. But higher debt also has higher risk, which reduces the firm’s value. By this measure, the best decision is to increase debt levels if the interest rate is low, and reduce debt if the interest rates are high. 

Increase Value

Another approach is to estimate the value of your firm without debt and then add the tax benefits of taking on debt while subtracting the risk (in dollar amounts) of bankruptcy. Basically, this approach allows you to measure the value of tax advantages and accelerated growth against the risk of bankruptcy. The optimal debt level is one where the value of the firm is maximized as per this formula: Firm Value = Unlevered Firm Value + (Tax Benefits of Debt - Expected Bankruptcy Cost from the Debt).

Research the Competition

Perhaps the easiest way to estimate an appropriate debt-to-equity ratio is to compare your company to others in the same sector. If you’re a small business selling toys online, for example, you could compare the debt ratios of other toy retailers with similar models to see if you’ve borrowed more or less than them. This should help you adjust your debt ratio accordingly and keep your venture competitive.

Remain Flexible

Finally, you could choose to have a flexible debt ratio to accommodate life cycle or seasonal changes. If your business is seasonal you can choose to borrow more at certain times of the year. On the other hand, if your business is still in the intense growth phase, you could borrow more to fund investments and pay back when your business has matured.

When it comes to business debt, one size certainly does not fit all. The key is to understand the impact of debt and create a strategy that applies financial leverage prudently.