Do you regularly consult the financial ratios for your business? You should. They are the gauges that tell you how well your company is running. One important gauge is the amount of debt the business has on its books compared to its equity base: the debt to tangible net worth ratio. This ratio is a measure of the financial health of your company and is an indicator of its ability to survive in tough times.
What is the Debt to Tangible Net Worth Ratio?
First, let's define tangible net worth. The equity in a business is found by taking the total assets of the company and subtracting the total debt. Total assets include cash, accounts receivable, inventory, fixed assets and sometimes, intangible assets such as trademarks, intellectual property and goodwill.
In the event of liquidation, intangible assets will probably not retain their reported value. Therefore, intangible assets are subtracted from the company's original equity amount to get the hard tangible net worth that represents the physical assets of the firm.
The debt to tangible net worth ratio is calculated by taking the company's total liabilities and dividing by its tangible net worth, which is the more conservative method used to calculate this ratio.
The formula is: Total Liabilities/Tangible Net Worth = Debt to Tangible Net Worth Ratio
Effects of Leverage
In general, the interest rate of debt will always be cheaper than the cost of equity. An investor who contributes equity capital to the business will expect a higher return, upwards of 15-to-20 percent or more. Interest rates on borrowed money are much lower, around 4-to-7 percent.
Suppose you're considering a project that will cost $2 million and is expected to return a minimum of 12 percent per annum. It would make more sense to borrow the money and pay 6 percent to make 12 percent rather than seek outside investors who will want 15 percent return on their money.
As long as the rate of return of a project exceeds the borrowing costs, you should borrow as much as the banks will lend. However, high amounts of debt increase the financial leverage of the business and make it more susceptible to economic downturns.
While taking on more debt may result in higher returns on investments, accepting more equity capital from investors means giving up a larger stake in your company. The objective is to strike a balance between a reasonable amount of debt to increase returns and not taking too much in equity capital to lose control of your business.
Meaning of the Ratio
One measure of the financial strength of a company is the ratio of its debt to tangible net worth. Companies with low amounts of debt compared to their tangible net worth are considered financially healthier than firms with higher levels of debt. A low amount of debt is good; a high level of debt is bad. Lenders do not like high debt levels because they feel it reduces the margin of safety in their loans.
But, to keep things in perspective, the appropriate debt to tangible net worth ratio varies by the type of industry. Utility companies, for example, invest in large amounts of fixed assets and have steady streams of cash flow. Therefore, they are allowed to have debt ratios up in the range of 4-to-6 dollars of debt to one dollar of equity. The debt ratios for banks can reach even higher into the range of 10-to-20 dollars of debt to one dollar of equity.
On the other hand, bankers don't like to see small businesses exceed a one-to-one ratio of debt to equity. Small companies don't typically have large amounts of equity capital, and their cash flows are less predictable.
However, a company with a high debt/net worth ratio does not necessarily indicate a problem. The business could be borrowing and spending money to promote the manufacture and introduction of a new product. If the project succeeds, the abnormally high debt level will start to decline.
While the debt to tangible net worth ratio is not a financial metric that a small business owner would monitor on a weekly basis, it is an indicator that should enter into financial planning strategies for the long-term.