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Understanding Debt to Equity Ratio for Early Stage Companies

June 22, 2018

 

In our earlier blog post, we have mentioned the different debt facilities offered by CII. At CII we assess the company holistically analyzing various aspects of the company like business model, social and/or environmental performance, financial performance, governance, process and systems etc.In this post we try to understand what the debt to equity ratio means for early stage companies.

 

Financial Leverage Ratio

Debt[1] to equity ratio is one of the common leverage ratios examined during ratio analysis. It examines the stake of owners in the company in relation to that of its lenders. Essentially it examines if the company has enough “Skin in the game”.

 

A wise mix of debt and equity can increase the return on equity for the following reasons

 

1. Debt is generally cheaper than equity. The cost of debt for early stage companies is usually in the range of 14-20% whereas the cost of equity is generally upwards of 25%.

2. Interest expense is tax deductible which effectively reduces tax liability whereas dividend to shareholders is paid from profit after income tax.

 

But again too much of debt is also not advisable because debt has a pre-decided repayment plan. Hence, as the quantum of debt increases, the stability of cash flows become of paramount importance. Unfortunately, for early stage companies (or even large ones), cash flows are never quite predictable with a 100% certainty. As a result, as the leverage increases, the lenders either don’t lend or the cost of debt increases (considering the riskier nature of lending).

 

What is in it for early stage companies?

Now the bigger question is that what is a healthy debt to equity mix for an early stage company? CII understands that concepts such as good/bad, or healthy/unhealthy are generally qualitative phenomena and the best use of ratio analysis can be made only by a comparative study and also taking into factor various other aspects of a company’s performance.

 

At CII we provide debt funding to companies where equity infusion has already been made by an institutional/angel investor and thus equity already forms a majority of the capital structure. Thus in most of the cases the debt to equity ratio is at acceptable levels.

 

As the company grows and incorporates debt in their capital structure to meet their short term to medium term working capital requirement (which is usually the requirement for early stage companies) the debt to equity ratio would increase. For a fast-growing profitable company, debt to equity ratio of 2 is considered acceptable. For companies that are backed by venture capital and have decided to grow first (without current period PAT profitability), the debt to equity ratio acceptable to lenders like CII is significantly lower. In fact, traditional lenders wouldn’t make a loan to loss making companies at all.

 

In addition to analyzing the acceptable debt to equity for CII or another lender, it is also important for the company to look into the certainty of the future cash flows and extent of debt that it can pay back over a given period of time, to decide the extent of debt.While reasonable and successful entrepreneurs are typically conservative (and savvy) about the extent of debt that the company can take, there are instances when companies expect that debt will play the role of equity, which cannot be the case.

 

Both investors and lenders expect returns. However, equity doesn’t come with pre-decided schedule of repayment except for a broad understanding that it needs to be paid back over a 3-5 year period in most cases. Each loan, however, has very specific repayment schedule and even if moratoriums are allowed, beyond the moratorium, there is a legal obligation to pay down the loans as per the schedule. The best use of debt is to meet working capital requirements or to finance part of capital expenditure (remaining being met through equity).

 

 

 

[1] Debt includes interest bearing liabilities both short term and long-term but excludes operating liabilities.

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