armember-membership domain was triggered too early. This is usually an indicator for some code in the plugin or theme running too early. Translations should be loaded at the init action or later. Please see Debugging in WordPress for more information. (This message was added in version 6.7.0.) in /home1/wanrru6iyyto/public_html/wp-includes/functions.php on line 6114ARMember domain was triggered too early. This is usually an indicator for some code in the plugin or theme running too early. Translations should be loaded at the init action or later. Please see Debugging in WordPress for more information. (This message was added in version 6.7.0.) in /home1/wanrru6iyyto/public_html/wp-includes/functions.php on line 6114Debt is a natural part of business. The most volume (number of transactions) of debt occurs with the simple purchase of materials (inventory) or supplies on account. Every business buys on account whether it is a traditional vendor account like that found in retail or simply using a credit card. A third party provides credit which creates debt for the business. The debt ratio reflects the percentage of assets covered by debt. The formula is as follows:<\/span><\/p>\n Debt\u00a0 Ratio\u00a0 = Liabilities Most small businesses have difficulty finding private capital for equity to fund assets especially assets for the expansion (growth) of a business. Assets are funded from two sources. The first source is equity<\/span><\/strong><\/a> which is customarily composed of the sale of ownership shares – stock and retained earnings (which are the lifetime retained profits from operations). The second source of capital to buy assets is from debt. Borrowing money is easier than obtaining capital equity. It is especially easier if the debt is collateralized like that required with bank loans. This chapter in the business ratio series explains the two underlying parts of debt, short and long-term liabilities<\/span><\/strong><\/a>. In addition, it will explain how they are calculated. This chapter goes further to elaborate on debt in comparison to the assets reported. Furthermore, leverage with debt is explained and why leverage is safer with some businesses and extremely risky with others. Finally, there are some nuances with debt that a reader should be aware of and how to discover and evaluate these critical aspects of debt. When done, the reader will have a greater appreciation of the debt ratio and how to apply this formula in evaluating performance of a business.<\/span><\/p>\n A typical balance sheet is composed of three major sections.<\/span><\/p>\n 1) Assets<\/strong> – Tangible (physical) and intangible items used to provide products or services to customers. The most prized asset is cash. Assets are considered one side of a balance sheet.<\/span> The debt ratio is merely the percentage of total assets funded with third-party money. It is one of the leverage group of ratios. Below is a simple balance sheet and the corresponding debt ratio.<\/span><\/p>\n \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 SMALL TOWNE BOOKS,\u00a0 INC.<\/span><\/strong><\/span> The debt ratio equals liabilities divided by assets.<\/span><\/p>\n Debt Ratio = $310,033<\/u>\u00a0 \u00a0= 81.4%<\/span> The debt ratio is really a summation of two elements of debt. Notice that liabilities are composed of current (short-term) and long-term liabilities. Both are compared against total assets for their respective percentage. Added together they equal the total debt ratio. Look at the results:<\/span><\/p>\n Short-Term Debt Ratio = Current Liabilities<\/u>\u00a0 \u00a0 \u00a0 \u00a0 =\u00a0 \u00a0$207,651<\/span>\u00a0 =\u00a0 54.52%<\/span> It is important to understand these two sub ratios have an interaction with each other as different industries will tend towards certain relationships.<\/span><\/p>\n All industries tend towards certain debt relationships on their respected balance sheets. For example, power generation companies make huge investments into plant, equipment and electrical distribution lines (grid). These investments are truly long-term (> 30 years) and therefore they are financed with long-term debt (usually bonds). If you look at a balance sheet for a power generation company you’ll find a 10:1 or higher ratio of fixed assets in comparison to current assets (cash, receivables and inventory).<\/span><\/p>\n The balance sheet’s liability section will tend towards a similar relationship associated with its current and long-term liabilities. In effect, the long-term debt will be greater than 10 times the volume of short-term debt. This relationship is essential as the asset structure should have a similar debt structure.<\/span><\/p>\n Let’s go back to the bookstore and evaluate its reasonably expected relationship and its actual relationship.<\/span><\/p>\n If you can imagine a bookstore, it is a shelving system loaded with books. It is not unreasonable to expect fixed assets to be less than current assets in value. After all, it isn’t as if book shelves are highly customized fixtures. Long-lived assets will more than likely have financing that is long-term. Here is the comparison in dollars:<\/span><\/p>\n SMALL TOWNE BOOKS,\u00a0 INC. In general, long-term debt should always be less than the corresponding fixed assets value; as more than likely, long-term debt was used to purchase fixed assets (long-lived assets). In this case, there is a poor matching of one asset group to its corresponding source of financing.<\/span><\/p>\n Take a look at current assets financing with current liabilities.<\/span><\/p>\n Current Assets\u00a0 \u00a0 \u00a0 –\u00a0 \u00a0 $297,403 This ratio is\u00a0 69.7% of current liabilities to current assets giving this relationship a current ratio of\u00a0 1.43:1 (which is fair). It is plainly obvious that some of the current assets are financed with long-term debt and\/or equity. In small business, this is actually normal. This is because small business owners often loan money to the company and agree to subordinate their position to the secured creditors. Sometimes the owners borrow money from the bank and personally guarantee the loan or use their personal fixed assets (equity in real property) as collateral. As a small business matures, often the long-term debt comes more in line with what an investor will find with publicly traded companies in a similar industry.<\/span><\/p>\n However, think about the bookstore business. There are three major assets; one is cash, the second are books and the third are shelves. Shelving is generally financed with long-term debt as explained above. However, books, magazines and publications are all short-term assets. The idea is to get them sold within 90 days (magazines within 30, publications within a few days). Therefore books are financed with vendor accounts. Some vendors will extend credit to 90 days or longer; but in general the secret to this business is the inventory turnover rate<\/span><\/strong><\/a>.\u00a0 What an investor will look to in this business is the relationship of inventory to vendor accounts. Any value greater than 1:1 (inventory value is more than payables) is a positive sign of financial management.<\/span><\/p>\n Ideally, an investor is looking for the company to finance a good portion of assets with equity and not debt. Why? Well lets look at two common public company drawbacks associated with too much debt.<\/span><\/p>\n Highly Leveraged<\/u><\/span><\/strong><\/span><\/p>\n Many publicly traded companies use debt to finance all of their fixed assets. Good examples include research businesses (chemicals, pharmaceuticals, oil exploration), airlines, shipyards, finance and real estate (REITs, apartment complexes, resorts). For these businesses, any slow down in economic activity greatly impacts their revenue stream and ability to service debt. Failure to service debt results in default and ultimately bankruptcy<\/span><\/strong><\/a>.<\/span><\/p>\n
\n<\/u><\/span>\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0Assets\u00a0 \u00a0<\/span><\/span><\/p>\nDebt Ratio Formula<\/span><\/strong><\/h2>\n
\n 2) Liabilities<\/strong> – Amounts owed to third parties for products or services rendered. Most liabilities reflect financing of assets.<\/span>
\n 3) Equity<\/strong> – The value or portion of assets that is owned or funded by owners of the company. It includes stock, retained earnings and current earnings.\u00a0<\/em><\/strong><\/span><\/p>\n
\n\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0Balance Sheet (Summary Format)<\/span><\/strong><\/span>
\n\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 December 31,\u00a0 2016
\n<\/span><\/strong><\/span>ASSETS<\/strong>
\n<\/u>Current Assets\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0\u00a0$297,403<\/span><\/span>
\n Fixed Assets\u00a0 (Netted)\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 68,997<\/span>
\n Other Assets\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a014,471<\/u><\/span>
\n Total Assets\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 $380,871<\/span>
\n LIABILITIES<\/strong>
\n<\/u>Current Liabilities\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0$207,651<\/span>
\n Long-Term Liabilities\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0\u00a0 102,382<\/span><\/span>
\n Sub-Total Liabilities\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0$310,033<\/span>
\n EQUITY<\/span><\/strong><\/span>
\n Common Stock\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0$50,000<\/span>
\n Retained Earnings\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a017,200<\/span>
\n Current Earnings\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a03,638<\/span><\/span>
\n Sub-Total Equity\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 70,838<\/span><\/span>
\n Total Liabilities and\u00a0 Equity\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0$380,871<\/span><\/p>\n
\n\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 $380,871<\/span><\/p>\n
\n\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0Total Assets\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0$380,871<\/span>
\n PLUS<\/span>
\n Long-Term Debt Ratio\u00a0 = Long-Term Liabilities<\/u>\u00a0 = $102,382<\/span>\u00a0 \u00a0= 26.887%<\/span>
\n\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 Total Assets\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0$380,871<\/span>
\n Equals Total Debt Ratio\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 =\u00a0 81.407<\/span><\/p>\nDebt Ratio Relationships<\/span><\/strong><\/h2>\n
\n<\/strong><\/span>Fixed Assets<\/u>\u00a0 \u00a0 \u00a0 Long-Term Debt
\n<\/u>$68,997\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 $102,382<\/span><\/span><\/p>\n
\n<\/span>Current Liabilities –\u00a0 \u00a0$207,651<\/span><\/span><\/p>\n