The financial structure of a business is usually a good indicator of the risks taken. This is something you need to become familiar with if you are thinking about investing in a business or are looking into funding your own business. Here is what you need to know about finances, debt, and equity.
What Is The Financial Structure Of A Business?
To put it simply, the financial structure of a business is the relation that exists between debt and equity. A business with healthy finances will typically have more equity than debt, while a business that takes more risks will have a higher amount of debt.
You probably won’t find a business that doesn’t have an existing liability. The purpose of analyzing the financial structure of a business is to assess how well the company is managing liabilities and what kind of attitude it has towards taking risks.
The debt of a business can be split into short-term and long-term debt. Examples of short-term debt include:
- Business loans.
- Accounts payable.
- Wages due to employees.
These are the most common types of long-term debts:
- Bonds issued to the public.
- Individual notes payable to investors.
- Leases and contracts.
- Pensions and benefits due to employees.
- Lawsuits that haven’t been settled yet.
The equity of a business can be valued by subtracting the total liability from the total amount of assets owned. Assessing the equity of a business can be difficult since not all assets are tangible.
A business’ assets typically include cash, accounts receivable, equipment, inventory, and a building owned by the company if applicable. You will have to add intangible assets such as intellectual property, the image and reputation of the brand, the size of the customer base, and even the employees’ talents and skills.
How Businesses Generate Capital
Businesses need to borrow money or raise funds from investors to generate capital. This capital is then invested to grow the business and generate revenues.
The capital structure refers to the strategies used to generate this capital. These strategies vary from one industry to another and can also differ in function of what the economy is like. A high debt ratio can become a serious problem if the economy is not performing well and the business can’t generate enough revenues to keep up with its liabilities.
Interest rates play an important role since low-interest rates make borrowing easy and can encourage businesses to rely on loans over other forms of financing. Analyzing the capital structure of a business will give you some insights into the strategies the business uses for financing and growth. The financial structure of a business will typically provide you with a more current snapshot of the business’ financial situations.
Larger companies will often generate financing by issuing stocks and securities. These companies are also likely to use loans since they can use assets as collaterals to secure low-interest rates.
Private investors often help raise capitals. This is a common strategy used by companies that mostly own intangible assets. Intellectual property and other intangible assets can’t be used as collaterals but they will help convince private investors. Companies with intangible assets also often issue bonds and securities.
Small businesses often have to rely on the owner’s savings. In 2012, 57 percent of small businesses were financed with personal savings while only 8 percent used bank loans. Personal savings were used in 22 percent of cases for expansion capital, and only 6 percent of small businesses used a bank loan for expansion capital.
Analyzing A Business’ Financial Leverage
Looking at the total amount of debt, equity, or assets of a business won’t give you an accurate idea of the kind of risks the company is taking. You need to calculate a company’s financial leverage to assess its financial health.
You can calculate the debt ratio of a company with this formula:
Debt ratio = Total debt / Total assets
The purpose of calculating the debt ratio is to assess whether or not a company has enough assets to cover the amount of debt owed.
Debt To Capital Ratio
The purpose of this formula is to assess how much of a business’ capital comes from debt. This is how you would calculate this ratio:
Debt to capital ratio = Debt / (Debt+ Equity)
Debt To Equity Ratio
This is the financial leverage formula for a company’s debt to equity ratio:
Debt to equity ratio = Debt / Equity
You can refine this ratio by calculating the long term debt to equity ratio:
Long-term debt to equity ratio = Long-term debt / Equity
Calculating the long-term ratio is more accurate since this formula does not include the immediate operational liabilities of the company, such as accounts payable due to suppliers. These two formulas will give you an idea of how much a company relies on borrowing for financing itself versus how much has been contributed by shareholders.
This is how you can calculate the equity multiplier of a business:
Equity multiplier = (Debt + Equity) / Equity
This is another way to assess how much a company relies on debt for financing. It is similar to the debt to capital ratio.
What Would An Ideal Financial Leverage Ratio Be?
There is no ideal financial leverage ratio for a business. However, you can assess risks by comparing a business’ financial leverage ratio with those of another company from the same industry.
Some industries typically see higher financial leverage ratios because businesses need to cover high upfront costs. A business that needs to purchase expensive equipment to start production or an industry with high entry costs tied to infrastructure investments would see businesses that rely heavily on debt.
On the other hand, an industry that mostly relies on intangible assets like intellectual property would see businesses that rely on equity to fund their operations.
You can also compare a business’ financial health by comparing the current financial leverage ratio with historical data. You might notice a sharp increase in borrowing once you compare the latest balance sheets with previous financial documents.
Typically, a debt to equity ratio that is higher than 2 should indicate a risk since the amount of debt owed is twice as high as the total equity of the company. However, you would have to differentiate between short-term and long-term debt.
Keep in mind that a high amount of long-term debt might not be an issue since the business will have plenty of time to invest this capital, grow, and generate more revenues. Refinancing a long-term debt is also possible.
If most of a business’ debt is due on the short-term, this is often an indicator that the business is about to face a crisis and might go bankrupt.
How to Assess the Financial Health Of A Company
You will need to obtain a business’ balance sheet to get an accurate idea of its financial situation. Ideally, you should have access to the balance sheets issued over the past few years so you can see how the business’ financial ratio has been progressing and assess the business’ attitude towards borrowing or relying on investors.
There are a few additional things to consider besides analyzing a business’ balance sheets:
- Does the business have a history of repaying debt on time?
- What is the company’s credit rating?
- Does the business have a history of implementing successful strategies for growth?
Once you are in the possession of a business’ balance sheets, pay attention to these figures:
- The amount of cash on hand.
- Total assets.
- Long-term debt.
- Short-term debt.
- Shareholder’s equity.
Start by calculating the cash ratio or liquidity ratio of the business. This isn’t a major indicator of a business’ financial leverage and health, but it is a good indication that the business is in control of its finances and will be able to take care of the short-term debt.
Cash ratio = Available cash / Short-term debt
A low cash ratio might not be an issue since businesses can typically generate cash by issuing more securities, or by simply waiting for a creditor to make a payment.
You can then calculate the debt ratio and the debt to equity ratio. If you obtain two low ratios, this is an indicator that the business has a strong balance sheet.
A low debt to capital ratio would be another indicator that the business has a conservative attitude towards borrowing, but a higher debt to capital ratio shouldn’t be problematic as long as the company has a solid history of investing capital to generate growth.
You can’t get an accurate view of a company’s financial structure if you only look at a business’ assets, equity, or debt. You need to analyze the relations between these different elements by calculating a business’ financial leverage. To accurately assess a business’ financial health, analyze its balance sheet and differentiate between short-term and long-term debts.