Cold morning light showers your back as you contemplate whether to file for bankruptcy or to continue believing in your startup’s mission. As your mind wanders, you think back to when you first set out to take on the market, what went so wrong, and what you could have done differently.
The risk of going belly-up should strike fear into any startup founder as the Small Business Administration estimates that: “About two-thirds of businesses with employees survive at least 2 years and about half survive at least 5 years.” Furthermore, a poll by Gallup reveals that about one-third of small business owners are uncomfortable with the amount of debt their business is in.
To some degree, debt is a measure of the risk that a business is taking on. The amount of debt in relation to a business’ equity and credit determines whether or not a loan is excessive.
The relationship between debt and risk
By successfully relating debt to risk, you’ll understand the why and when of taking on debt for a business. Business owners should understand debt as a function of risk.
The debt-to-equity ratio is in part a statistical way for business owners to conceptualize the nature of debt through the amount of financial leverage it possesses. In simpler terms, the debt-to-equity ratio quantifies what you using against what you have. To avoid excessive debt, you should generally aim to keep your business’ debt-to-equity ratio below 2.
The math behind excessive debt
So how does the debt-to-equity ratio connect the concepts of debt and risk? The value of your equity is essentially a measure of how the market and society values your business currently, while the amount of debt you’re taking on might be thought of as your own advance on how much your business is worth. Knowing the ratio between the two will help you understand just how big of a risk you are taking – this is equivalent to the excessiveness of your debt.
Let’s say I own a lemonade stand that has shareholder equity worth $100. If I take out a loan of $50, it means that I have a…
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