What is an ideal debt equity ratio for any young business? 60/40 or 70/30? "The debt equity ratio is simply the amount of debt you have on your balance sheet divided by the amount of equity. There is no fixed ratio," said Binod Shankar, managing director at Genesis Institute, a financial training company that specializes in corporate training.
However, recognize that equity is more expensive than debt in the long term, noted Edward Roderick, co-chairman and managing partner at Envestors MENA, a UK-based business angel network with an active regional presence in the Middle East headquartered in Dubai. "In the short term, equity might be good because it is the only source of funding that you have available. In the long run, it takes a proportion out of your business and you are expected to pay dividends at some point or the other," he said. Zawya asked the experts to explain if there is an actual perfect debt equity ratio and how to maintain the right balance. The verdict..
Examine volatility: "Business risk is critical. If the business is cyclical/volatile or unpredictable or both, then it is a high-risk business - for example, a trading company. In that case you should reduce your financial risk and a major element of financial risk is debt," said Shankar. "This is necessary because volatility may mean that you may have to skip some fixed loan payments leading to default, reputation damage and so on. On the other hand if the business risk is low (stable, predictable, annuity type of business), then you can afford more debt - a good example is power or water generation."
Risk appetite: An appetite for leverage is also important. "Some people do not like to borrow even if there is a good chance to make more money with the borrowed funds," said Shankar. "This is largely psychological and has little to do with the commercial or financial aspects of the situation.
Assessment factors: "Creditors should look at the debt ratios to decide if they are going to extend loan to the business and to determine the interest terms," said Iyad Mourtada, managing director at OpenThinking, a business learning platform for executive development in leadership, entrepreneurship and innovation. "Debt ratios will show how much the percentage of the debt compared to the equity and if the company is earning enough money to pay the interest payments. Investors look at the equity ratios to examine how much return they will get for their investment and how much equity the firm uses in its financing."
Working capital first : "When it comes to deciding on the debt equity ratio, an entrepreneur needs to figure out how much they need to borrow, their ability to repay and service and whether it is a long term facility needed for expansion or working capital," said Ehsaan Uddin Ahmed, Global Transactions Services and SME head (Corporate Banking Group) at Noor Islamic Bank. "My advice is to first think about working capital rather than taking long-term project finance. If the entrepreneur needs it for working capital, then they should examine the cycle that they are trying to optimize in terms of the receivables and payables cycle and to understand how much is needed. A 60 to 70% equity is considered a right level. A figure above that will change the nature of the business." Leading to imbalances.
Interest charges: Most of the time, entrepreneurs are not looking at giving away more than 20 to 40% of the business, said Roderick. "So in a debt to equity ratio, professional companies' advice that interest charges must be covered in four times by the operating profit. It depends on the interest rate in application at that time and the degree of your leverage. But you also have to look at the average performance on the interest rates in order to make a judgment on that." The entrepreneur has to juggle the numbers before making the leap. © Zawya BusinessPulse 2013
However, recognize that equity is more expensive than debt in the long term, noted Edward Roderick, co-chairman and managing partner at Envestors MENA, a UK-based business angel network with an active regional presence in the Middle East headquartered in Dubai. "In the short term, equity might be good because it is the only source of funding that you have available. In the long run, it takes a proportion out of your business and you are expected to pay dividends at some point or the other," he said. Zawya asked the experts to explain if there is an actual perfect debt equity ratio and how to maintain the right balance. The verdict..
