How debt to equity ratio affects business operations

By Odhiambo Ocholla

There are two types of financing available for businesses, debt and equity. When company decides to how to raise additional capital, the advantages and disadvantages of each type of funding will need to be considered. When looking at your debt to equity ratio, you will need to have a few things ready before you begin.

First, have all your company’s financial records together.

Secondly, discuss the possibility of outside investors. The debt to equity ratio measures the amount of money your company can safely borrow over a specific amount of time. To obtain your ratio, you will compare the total debt and divide it by the amount of the owner’s equity. Debt and equity are accounted for differently and each has a different impact on earnings, cash flow, and taxes. The composition of equity and debt will also have an effect on the weighted average cost of capital (WACC). The way your company uses their funds will affect the financing options and debt to equity ratio.

Equity funding

Equity on the other hand differs from debt as it represents a permanent ownership in the stake of the company. If you are financing with equity, you are giving up a portion of your ownership interest in the company in exchange for cash. Equity investors are typically contributions from business associates, family, and friends. Equity financing is typically a long-term funding option that is not associated with a specific amount of time. Your business finance depends on the proper balance of debt and equity.

If you have too much debt, you will overextend your ability to pay and this will be vulnerable to larger interest rates or penalties. However, too much equity will affect your business ratio if your ownership interest is exposed to outside control. It’s significant to note that debt to equity ratio needs a proper mix and it’s determined by the type of business, its age, and some other factors. An acceptable debt to equity ratio is considered 1:2 or 1:1. Depending upon your industry, this ratio will vary.

Cost of capital

Capital costs are influenced by the returns that are expected by the investors and lenders which in turn are a reflection of the risks they take. The management of the company will have to decide on the form of financing that represents the most effective cost of capital. The capital structure, the amount of debt a company takes on in relation to its equity, will also have implications for the WACC of the company as a whole. The lower the WACC of a company, the higher its return on equity will be. However the higher the gearing, the higher the risk that debt cannot be serviced and company may get into difficulties and the equity holders will in return expect a higher risk premium. So the cost of equity capital will rise with an increase in gearing. So when a company that is wholly equity financed introduces debt into the capital structure, the cost of equity capital should increase.

Capital Structure

There are a few things investors need to know about how debt to equity ratio affects business finance It’s significant to understand exactly how much the business can realistically afford to spend on debt repayments each month. You will need a detailed list of your company’s assets as lenders will want to know the collateral you have. It’s important to know the economic factors that can impact on the debt to equity ratio as the economy is constantly changing. It is also significant to note that any change in the capital structure is likely to provoke some market reactions and it is therefore necessary to determine how any change i.e. raising more debt will be perceived by shareholders, lenders and rating agencies. Shareholders may prefer a company to raise debt rather than equity because it increases return on equity. But also raising additional equity could result in a dilution of earnings per share. Major funding decisions have to reflect the level of debt to equity and types of instruments used.