By Sandra Taylor-Sawyer
Last month’s column included discussion of important financial statements owners of small businesses can use to analyze the financial condition of their business. This column continues the discussion with information about another important financial ratio: debt to equity.
A balance sheet is needed to obtain the information to compute the debt-to-equity ratio. A balance sheet documents assets, liabilities and owner’s equity transactions a business will have on a daily basis. Assets of a business are best described as items or things the business owns; liabilities represent the debt of the business; and owner’s equity is the owner’s contributions to the business.
The debt-to-equity ratio is computed as total liabilities divided by owner’s equity.
The balance sheet provides the information needed to compute the ratio.
For example, if Company B’s total liabilities were $800,000 and owner’s equity $325,000, the computation would be 800,000/325,000 = 2.46. This means for every $1 the owner has contributed to Company B, creditors have contributed $2.46. The debt-to-equity ratio may be too high, which means the business is classified as “low safety.”
One solution for the owner is to invest more money in the business (add more capital). Another solution that may be more practical is to slow growth, thereby allowing profits to reduce liabilities instead of creating more debt by purchasing assets.
The other main financial statement as discussed in last month’s column was the income statement (profit and loss). This statement represents all income derived from the sale of products or services and allowable expenditures of a business, with the difference between the income and expenditures being net profit or net loss. The income statement is the document most business owners review monthly.
The amounts on the income statement are used to compute the “profitability ratios” of a business. The profitability ratios assist in determining the ability of management to control expenses and earning a return on the owner’s investment in the company (“Financial Analysis: Tools and Concepts” by Jerry A. Viscione).
The gross profit margin ratio is a profitability ratio. The computation for gross profit margin is gross profit divided by sales. Gross profit of a business is sales minus the cost of producing the goods (cost of goods sold).
If a business had sales of $953,765 and the gross profit was $400,000, the gross profit margin ratio will be 42 percent (400,000/953,765). The 42 percent means for every $1 of sales a company makes, $.42 is generated in gross profit. A slight change for gross profit margin from one month to the next indicates a sizable shift in the profitability of a company.
As with all financial ratios, it is important to compare the ratios generated from month to month and year to year, and always with ratios from same-size businesses within the same industry.
Sandra Taylor-Sawyer is director of the Small Business Development Center at Clovis Community College. Call the center at 769-4136 or visit www.nmsbdc.org/clovis.