This is a four-part online series on financial statement basics adapted from an article on credit and finance in the July-August 2022 issue of Produce Blueprints. To read the full issue online, click here.
The main leverage or debt ratio of the balance sheet is the debt ratio.
This ratio determines what percentage of a company’s assets are held by the company compared to credit institutions.
The debt ratio is calculated by taking total debt and dividing by total equity.
For the balance sheet in Table 2, the 2021 debt ratio would be 1.33:1, or $200,000 to $150,000. This ratio shows that for every dollar of equity, the company has $1.33 of total debt.
How much is too much leverage? It comes down to the historical performance and return of leveraged assets. And, from a comparable perspective, understanding the industry and/or sector in which a company operates is also helpful.
A company that operates as a broker will likely have limited bank debt, while a wholesaler or repackager may have significant debt associated with and necessary for its operations.
The key to leverage is balancing current maturities with equity exceeding debt due to profitability.
The operating partner mentioned in the introduction to this article acquired the skills necessary to balance both sales and finances for the business, and eventually bought out the investor.
The company continues to operate today and is very successful.
Not everyone is lucky enough to have a mentor.
As with many new startups, the investor believed that if the operating partner went it alone, sales wouldn’t have been an issue, but balancing sales with limited financial expertise could have written a very different story for the company. .
For those running a new business and who may have limited financial experience, this article should help. The importance of understanding a company’s financial condition is critical to its success.
There are thousands of small businesses like the one mentioned here where the combined efforts of an operating partner and a seasoned investor have paid off. There are also thousands who have failed due to financial mismanagement – don’t become a statistic because of financial illiteracy.