Debt to equity ratio
Contenidos
Debt to equity ratio
Companies have both equity (money provided by shareholders) and borrowed money (liabilities to be repaid) for their operating cycle. Given the different costs of both resources, companies have to find an optimal ratio between the two sources of financing.
Through the debt-to-equity ratio, the company can quickly find out what its equity structure is like and whether it is affordable and efficient. Thus, the debt-to-equity ratio tells us how much the company has borrowed (and is burdened with interest) in relation to what the shareholders have put in out of their own pockets.
Although the calculation is simple when it comes to interpreting it, it is necessary to know how it has been calculated. This is because, depending on the analyst or data provider, it can sometimes be calculated in different ways. In general, net financial debt is considered to be long-term debt (non-current liabilities) and short-term interest-bearing debt (short-term interest-bearing liabilities). These are the debts that generate an interest payment and therefore represent a cost to the company.
equity financing advantages and disadvantages
1. How much do I need to finance: What is the total amount I need to undertake my project? Do I need 100, 200… 600? This involves analyzing the investment requirements based on our business plan.
2. How am I going to finance it. Where will the financing come from? This involves determining the financial structure of our project: the origin of each of the funds I am going to count on. And this is what we are going to talk about today.
Is it possible for my project to be totally or almost totally self-financed? This would mean, for example, that I can start with a phase 0 that requires a minimum investment (starting from a minimum viable product) and, once it starts to generate cash flows, I will reinvest them in the project itself to improve and expand it.
We can think of the example of a person offering a consulting service: He can start working from home with an old computer and meeting his clients in a coffee shop. Investment = 0
However, beyond a few examples mainly related to the provision of services, it is usually necessary an initial start-up financing of our project that must be provided “from outside”: External financing, understood as all that is external to the project itself. This includes us as investors who launch the project but also third parties from whom we “borrow” the money.
equity financing
The problem in this area of finance is to determine the most appropriate debt to PR ratio. In order to compare different financing structures, the average cost of capital criterion is applied, among others: between two financing alternatives, the one with the lower cost of capital is chosen.
Since the net profit corresponds to the shareholders and they apply a capitalization rate of 12%, the market value of the equity is obtained by applying the formula for a perpetual income, amounting to 390/0.12 = 3250
If the company can replace equity with debt, and if the cost of debt is, for example, 10%, it will be able to reduce its average cost of capital, since it will replace resources which it has to remunerate at 12% with cheaper ones, which require only 6.5% [10 x (1 – 0.35)] after tax. If the cost of capital K0 decreases, the valuation of the company will consequently increase, since the profit will be capitalized at a lower rate.
equity financing
In accounting, equity is the part of the liabilities that is not due to external financing but to the contributions of the shareholders and the profits generated by the company. It is the sum of share capital, reserves and results for the year. [1]
Shareholders’ equity is usually considered as net worth within a balance sheet, however, they are considerably different. [2] While both are considered within accounting as non-callable liabilities, shareholders’ equity is obtained from within the company.[1] If a company depletes its shareholders’ equity by the end of the year, the company’s shareholders’ equity is used up.
If a company exhausts its shareholders’ equity due to accumulation of losses, it goes bankrupt, which is the situation that occurs when the sum of its assets is less than the sum of its liabilities due, i.e., it lacks sufficient assets to pay the debts contracted with third parties. Therefore, a company’s equity is an important measure of its financial soundness.[1] A company’s equity is a measure of its financial strength.
Relacionados
