What is the personality of your business? Debt to Equity Ratio explained

shark tank

 

Each of the sharks above have a different personality and propensity for risk.  Mr. Wonderful want to know you know your numbers or else he retorts "you are dead to me!"

Mark Cuban mulls quietly and pounces quickly often shutting the other sharks out.

Even though they are billionaires they worry if they invest with you, how will they get their money back?  They want to know what kind of risk taker you are and how safe their money will be.

In our last blog (Making Money from Other People’s Money) we discussed the role of Debt in helping you with your wealth creation strategy.  

The key insight was if your business generates a significantly greater return than the interest rate at which you can borrow money then increasing your debt is an effective strategy for growing your company.

Now we are going to layer on a second component to managing debt, something the sharks look for, are you disciplined in the way you consider overall business risk.

There are only two ways to fund your business:

Your Own Money (Equity)

Other People’s Money (Debt)

 

The proportion of these two sources of funding is known as the Debt to Equity Ratio.

So if your total Equity is $200,000 and your Debt is $100,000 your Debt to Equity Ratio is 50%.

$100,000/$200,000 x 100 = 50%

 

Stated in different way, for every dollar you borrow from the bank you have $2 of you own money invested in your business.

Each week, the shark's ask prospects "how much money have you got in the busienss and how much debt do you have?".  They want to know your Debt to Equity position and how much skin in the game you have.

When you go to lend money from the bank they look at your risk and offer you a deal (interest rates and certain covenants governing how and when you will pay them back).  The less risky the deal the better the terms they will offer.

Think of it like buying a house.  Long gone are the days when the bank would invest 100% and you put no money of your own down. The discovered that was way too risky.  The more money you put in the better the interest rate they give you.

Your Debt to Equity is indicative of the risk taking personality of your business—are you very conservative or are you an aggressive risk taker?

 

Here are 3 personality profiles:

 

1. No debt Ned

No debt Ned 3

 

Debt to Equity ratio: 10%

 

He is very conservative and resistant to taking on any debt.  His family taught him never to borrow money and never have any credit card debt.  The consequence is he has to finance all his business needs with cash. He has to very diligent in converting profit into cash and use only his cash reserves to grow his business. If these cash reserves are available he can grow, if not he cant. Taking on good growth opportunities are often severely limited. Often Ned finds the pace alittel too slow and wished he cold grow faster.

 

Bad Debt Billy.

Bad Debt Billy

 

Debt to Equity Ratio: 200%

 

Billy is willing to take risk.  He doesn’t fully understand the risks associated with having high debt and low equity. Consequently, some of the risks he takes can be fatal at worst and debilitating at best.  If his business has a slight change and operates at lower profit he will generate less cash.  He can’t go and get more cash as his Debt to Equity is already seen as risky by the bank.  Sadly, Billy spends most of his time chasing cash, trying to make all his payments and lurches from one period to the next consumed with worry.  And when he is worried he is not focusing on his customers.  Whn he is not focusing on customers he loses sales.  less sales means less profit and a vicious death spiral sucks him slowly and painfully into the abyss of bankruptcy.

 

Good Debt Deb.

God Debt Deb

 

Debt to Equity Ratio: 50%

 

Deb is a savvy businesswoman.  She is at peace with her debt knowing she can make money from other people’s money. She has a clear strategy of how much debt she is willing to carry. She is happy with her debt to equity relationship that enables her to know how much maximum debt she can carry with acceptable risk and still make good money from other people’s money.

Good debt Deb has a competitive advantage, she can take on the right opportunities when they arise while focusing her attention on what the business does best.  The sharks would probaly want to invest in Deb--she has the business risk personality they admire.

 

So understand your Debt to Equity ratio (Just find Debt and Total Equity on your balance sheet and calculate Debt/Equity x 100.

What does it say about your risk personality?  Are you comfortable with it?

 

Successful business owners combine Making Money from Other People’s Money and Risk to get the most out leveraging debt.

 

Questions, comments—please let us know.

How to Make Money using Other People’s Money
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Wednesday, 12 December 2018

Mick Holly & Andre Gien

Wealth Scientists

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