Just as having equity in your home strengthens your financial standing and flexibility, so too does having equity in your business.
The concept is the same: your business is financed by a combination of “other people’s money” and your own. Your home’s financing is typically provided by a single loan (or two). Business financing comes from a variety of sources – vendors/AP, credit cards, loans and, perhaps most significantly, customer deposits and advance payments (these are loans, not income).
It’s smart to use “other people’s money” to finance your business. What’s not so smart is to have too little of your own money in the game. The less equity you have, the more leveraged and vulnerable your business becomes. Fortunately, it’s easy to determine equity and debt.
Balance Sheet 101
The three sections of a balance sheet reveal a company’s financial standing:
What your company “owns”. There’s cash in the bank, money that clients owe you (AR), goods in the back room (inventory), vehicles, and more. Assets reflect what your company has done with its profits.
What your company “owes” – accounts payable, credit card balances, customer deposit liabilities, accrued sales and payroll taxes, and loans. Other people’s money.
The difference between what you “own”, and what you “owe”. Equity is the sum of four primary components:
- Capital Stock – amounts invested in the company by the owners
- Retained Earnings – how much money (net profits after taxes) the company has earned over time
- Distributions/Dividends – how much retained earnings have been distributed to the owners over time
- Current income – net profits posted in the current year
Leverage is measured as a ratio of debt (liabilities) to equity. $800K in liabilities with $200K in equity equals 4:1 leverage. About as high as you want to go.
Retained Earnings vs Taxes
At the end of every year, profitable businesses are required to pay income taxes. What’s left after paying taxes becomes part of the company’s retained earnings accumulation. The only way to grow equity (besides bringing in additional owners/investors) is to accumulate retained earnings – make money year after year – and leave a healthy amount in the company. The companies that do this become less and less vulnerable to short-term downturns in business, and are able to finance their growth with minimum risk.
But it’s not what we see companies do. Without regard for what it does to equity, many owners take distributions and/or pay themselves bonuses just because there is a good amount of cash on hand. And at tax time, they often spend money (vehicles, bonuses, owner-favored deferred income plans) as a way to minimize income. These might be good tax strategies, but might NOT be good for the financial health of the company.
It goes without saying that companies with negative equity are on thin ice. These companies must do everything they can, as quickly as they can, to accumulate earnings and reduce debt.
The goal is be at or below 2:1 leverage. Owners of such companies sleep better at night!
NOT ALL LIABILITIES ARE CREATED EQUAL
Each liability on the balance sheet carries some cost, usually. Client deposits and AP could be considered free money with no cost. Actually taking advantage of prompt pays receiving discounts not only reduces liabilities but helps profitability as well. Bank loans typically have interest. Credit cards can too if balances are not paid on time. Tax liabilities do not have specific financing cost but are a requirement for doing business.
The point being, beyond the debt/equity ratio, having liabilities that are cost free is more desirable. Companies with 90 days of client backlog and very proactive deposit taking and request for payment practices will have a higher ratio but with little cost to the business.
Build Equity. It ultimately is the difference between winners and losers.
Keep it Vital.