Calculating Leverage Ratios

Leverage Ratios indicate long-term solvency of a business and highlight the extent to which long-term debt is used to support the business.

These ratios include:

DEBT-TO-EQUITY RATIO

The Debt-to-Equity Ratio measures how much debt is used to run a business and further highlights how much debt the business has for every dollar of equity. The formula is as follows:

Debt-to-Equity Ratio = Total Liabilities/Shareholders Equity

In most cases, investors would want to this ratio to hover around 1.0 or slightly less.  Higher ratios suggest the company may be in financial distress, while lower number suggests the company is relying on equity financing which may be too costly and inefficient for the business.

DEBT-TO-ASSET RATIO

The Debt-to-Asset Ratio measures the percentage of a business's assets that are financed by creditors. The formula is as follows:

Debt-to-Asset Ratio = Short-Term Debt + Long-Term Debt/Total Assets

Most investors and lenders see a lower ratio as a good indicator to repay debt and take on new debt for new opportunities; a higher ratio might suggest financial weakness.

While these formulas are straightforward, I have created a spreadsheet calculator for readers to use an explore. If you're interested, you can download the Leverage Ratio Calculator using the button below. If you would like to learn more about Financial Ratios and how they may be used, read the post, Financial Ratio Analysis and the Entrepreneur.

A few notes on this calculator:

• This calculator is an example and is for use as is. It is not supported in any way. It is not intended to be a tool to use without customization based on the specifics of an entrepreneurial venture and its unique financial statements.
• This calculator is only an example to give the reader an idea of how such a tool can be developed. The numbers within are not based on a real business. I compiled this as an offshoot of work in a graduate class, but I have created developed similar models for entrepreneurial ventures. Each business venture is different, and so is the ratios used and considered for that enterprise.
• Financial Ratio calculations are done annually using actual numbers. This model can be used in that way. It can also be used to calculate and review ratios monthly. Monthly numbers would allow the reader to track improvements over time.
• All of the “Bold Blue” text areas can be changed to demonstrate how the interactivity might work. No other data can be changed.
• Formulas can be seen in each of the cells (mouse over it), but only the values in the “Bold Blue” text area can be changed.
• By downloading you acknowledge this is for personal use only. It is not to be sold or distributed in any way.

Reference

Rogers, S. (2014). Entrepreneurial Finance: Finance and Business Strategies for the Serious Entrepreneur. New York: McGraw Hill Education.

Financial Ratio Analysis and the Entrepreneur

Lenders, and often investors, will calculate one or more financial ratios when reviewing an entrepreneur's financial statements to gain a quick understanding of the health of the business before determining whether to lend or invest. Within an industry, there will be “good” and “bad” benchmarks against which the venture will be measured (Rogers, 2014). Investors and lenders will consider the particulars of a business and likely weight the importance of the ratios differently when comparing to the industry benchmarks.

Many financial ratios could be applied, but the following appears to be most common types (BDC Staff, n.d.):

Leverage Ratios. Leverage Ratios provide an indication of the long-term solvency and highlight the extent long-term debt is used to support the venture.

Liquidity Ratios. Liquidity Ratios measure the businesses ability to cover its debt and provide a high-level overview of financial health.

Efficiency Ratios. Efficiency Ratios provide insights into operations and help to spot problem areas related to inventory management, cash flow, and collections.

Profitability Ratios. Profitability Ratios evaluate the financial viability of a venture and provide a measure of comparison and performance to the venture’s industry.

There are other ratios, of course, and as mentioned before investors particularly have ratios they rely on more based on their experience and industry knowledge. For example, a recent interview with an investor uncovered a preference for knowing the Customer Acquisition Costs. Customer Acquisition Costs are not often viewed as part of a Financial Ratio Analysis, but such factors are often important measures for both investors and entrepreneurs alike.

The entrepreneur, investor, and lender can gain useful information and financial trends on a business venture when using Financial Ratio Analysis. However, it is important to note that financial ratios have little meaning without comparison (Peavler, 2017). For example, a company can compare its ratios to those average ratios of their industries, but the best and most accurate comparisons come from using benchmark companies—high performing companies within their industry. Comparisons against these companies can create and encourage stretch goals for a business.

While Financial Ratio Analysis does provide numbers for performance comparison, it does not provide causation factors (Peavler, 2017). Moreover, identifying why certain ratios that are out of line with the benchmark comparisons is critical because it provides a starting point for correcting problems and improving financial performance.  Ratio analysis can have value for entrepreneurs but depending on where the venture when it is seeking funds, these ratios may or may not be helpful in securing financing.

Entrepreneurs seeking early-stage financing are more likely to encounter investors who value continual improvements in customer acquisition costs, improvements in customer engagement at the various points of contact, and repeat purchase or purchase frequency. These measures help the investor gauge the interest in the offered products and services and are often a good predictor of long-term revenue.

Conversely, established entrepreneurial ventures—those that have several years financial history—looking for ongoing financing are likely to find as much emphasis placed on financial ratios as is placed on the customer measures noted above. This particularly true with bank financing because bankers are more risk adverse and financial ratios when properly utilized, provide a more objective measure of a venture’s performance compared to its industry thereby giving bankers a greater level of comfort when lending money.

Entrepreneurs are often motivated to launch a business in part because of their interest and expertise in a specific domain area. However, many entrepreneurs may be less skilled when it comes to the business finances beyond the basics of revenue and expenses. As an entrepreneur’s business grows, understanding key aspects of finance becomes increasingly more important, particularly should he or she seek outside investment or financing. It is important to understand the basics of Financial Ratio Analysis and how it can be used to determine the health of a business before seeking investment or financing. Yet it is equally important to understand that Financial Ratio Analysis is only one tool in an investor or lender’s tool-box. And while it is an important tool, it is not the only tool that might be used, particularly by investors, when determining the probability of long-term success of an entrepreneurial venture.

References

Peavler, R. (2017, February 28). Limitations of Ratio Analysis. Retrieved September 30, 2017, from thebalance.com: https://www.thebalance.com/limitations-of-financial-ratio-analysis-393236

Rogers, S. (2014). Entrepreneurial Finance: Finance and Business Strategies for the Serious Entrepreneur. New York: McGraw Hill Education.

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Startup Funding Option: Strategic Alliances

Entrepreneurs often look to friends, family, their bank account, and even credit cards when funding a startup, but many perhaps overlook this startup funding option: The strategic alliance.

A strategic alliance is a cooperative arrangement between two or more businesses for the mutual benefit all involved businesses. The idea is that each involved entrepreneur or business entity brings something to the alliance which enables a greater opportunity for near-term successes for all parties than the parties might achieve individually. While it is possible one company might invest in another to gain access to products and services more quickly that it might develop the same for itself, the more likely scenario is one in which two companies with complementary services align to improve long-term revenue generation opportunities.

For example, one entrepreneur with design experience might align with another entrepreneur with software coding experience to form a structured partnership to pitch new software projects to a prospective client or develop a software-as-a-service (SaaS) application to offer to a broader customer base.

Another example might be a larger company that needs support products or the services provided by a startup and agrees to partner to gain access to that startup’s offering. More specifically, a mapping software company may find it has difficulty selling its software for certain business applications. It could partner with a business consultant who understands how to apply business thinking to the software tools to help a prospective customer better understand the software’s value. When a sale occurs, the consultant helps implement the software and train the client.

There are challenges to strategic alliances, of course, particularly among startup ventures. The biggest obstacles appear to be a difficulty in finding suitable cooperating partners, an inability to assess the upside and downside of the alliance accurately, the challenge of properly structuring the arrangement, and the fear that cooperation might result in an expropriation of business (Hsu, 2007). Moreover, some alliances can pose a challenge to future investment funding if investors have a conflict with one or more of the alliance partners, or if cash flow rights to alliance partners dilute the opportunity for investors (Ozmel, Robinson, & Stuart, 2012). However, if entrepreneurs are open to such alliances, these obstacles can easily be overcome with the support of experienced business mentors, attorneys, and accountants.

Simple strategic alliances might occur with a “memo of understanding” that outlines what each party in the alliance will bring to the table, while a more complicated partnership might involve a formal agreement which holds each involved party accountable for providing the products and services to be delivered jointly to a customer. The most complex alliance might require the formation of a joint entity such as a corporation or limited liability company where all parties have ownership relative to their level of responsibility and risk in the alliance. The structure chosen is dependent on the products and services offered, the desired outcome of the collaboration, and the level of tolerance for risk by the parties involved.

While strategic alliances do provide an option for funding a startup or small business, it is important to remember that most strategic alliances do not usually result in a direct investment for an entrepreneur’s business. Instead, the alliance should enable an entrepreneur to secure his or her first projects or to create the initial products necessary to launch or grow a business. As a source of funding, the goal of a strategic alliance is to facilitate new opportunities, to improve the probability of cash flow, or in the case of a startup, to get a business off the ground. Finding and aligning with the strategic partner might be the first step to securing the funding needed for long-term success.

Reference

Hsu, D. (2007). Venture Capitalists and Cooperative Start-up Commercialization Strategy. Management Science, 52(2), 204-219.

Ozmel, U., Robinson, D., & Stuart, T. (2012). Strategic alliances, venture capital, and exit decisions in early-stage high-tech firms. Journal of Financial Economics, 107(3), 655-670. doi:10.1016/j.fineco.2012.09.009

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Featured Image Source: Getty Images/Jose Luis Peleaz Inc.