Debt to Equity Ratios and All That Jazz – An Entrepreneur’s Primer on Financial Statement Terms

You are an Entrepreneur.  You have to be good at what you do. You must provide your core service, manufacture your core product, or sell your core goods, effectively. Just being good at what you do is not enough, however. As an entrepreneur, you must also be good at managing the business of what you do.

A key part of managing the business of what you do is understanding your business’s finances. I wrote before about the four basic financial statements, what they are and how they relate to one another. I will be writing about the Profit and Loss Statement and the Balance Sheet in more detail soon.  First, though, I want to write about some basic financial terms that every entrepreneur must know.

Balance Sheet Terms.  You balance sheet lists all of your business’ assets, liabilities and equity on a particular date. To understand the balance sheet, you must understand:

Assets. Assets are all of the things with a monetary value the company owns: Cash, securities, accounts receivable, inventory, land, buildings, vehicles, furniture, intellectual property. Assets are generally things that can be sold to somebody else.

Liabilities. Liabilities are the debts of the company:  Money owed to suppliers (trade debt), debts owed to banks or other lenders (notes),accounts payable, taxes due. Anything the company owes to someone else that must be repaid is a liability.

Equity. Equity is the net asset value of the company to its owners at any point in time. Equity reflects the amount the owners have put into the company (unless an owner made a loan to the company, which is a liability), plus retained earnings, or minus retained losses.  On a balance sheet, the Assets always equal the Liabilities + the Equity. That’s how the balance sheet ‘balances’. To calculate your company’s Equity, then, you subtract the Company’s Liabilities from its Assets.

Debt to Equity Ratio: Your company’s debt to equity ratio is calculated by dividing the Liabilities by the Equity.  A company with $1,000,000 in Assets, $750,000 in Liabilities and $250,000 in Equity (remember, Assets = Liabilities + Equity) has a debt to equity ratio of 300% (meaning that creditors are providing 3 times more to the company than the shareholders). Lenders and investors care about the debt to equity ratio – the more debt you have in comparison to your equity, the less likely you are to attract a lender or investor.

Debt Ratio: Your company’s debt ratio is calculated by dividing the Liabilities by the Assets. The same company as above,  with $1,000,000 in Assets, $750,000 in Liabilities and $250,000 in Equity (remember, Assets = Liabilities + Equity) has a debt ratio of 75%. The higher the debt ratio, the more “leveraged” the company is. Debt ratios vary widely across industries, with capital-intensive businesses such as utilities and pipelines having much higher debt ratios than other industries like technology.

Profit and Loss Statement Terms. The profit and loss statement (also known as the P&L, or sometimes as the Income Statement) lists your company’s sales and expenses over a defined period (a month, a quarter, a year) and is used to work out the gross and net profit of a business. To understand a P&L, you must understand:

Sales. The money your company receives in exchange for its goods or services. Also called Revenue. On a cash basis P&L, this is money your company has actually received.  On an accrual basis financial statement, the sale happens and the revenue is booked when the goods or services are delivered, whether or not there is immediate payment.

Cost of Sales (also called Cost of Goods Sold). This is the cost of the raw materials and assembly of what your company sells, or the cost of the finished goods your company resells, or the direct costs of delivering the services your company delivers. This is what a manufacturing company pays for raw materials, what a bookstore pays the distributor for the book they sell, what a construction company pays a laborer for providing direct labor on a project, or a law firm pays an associate or paralegal for work on a client’s legal matter. Costs of Sales are the variable costs incurred only if a sale is made, rather than the fixed costs (rent, administrative salaries, interest payments) your company incurs whether a sale was made or not.

Gross Profit (also called, confusingly, Net Revenue). This is simply Sales – Costs of Sales. It is the profit the company has after paying its direct costs of sales, but before paying any expenses.

Operating Expenses. Office rent, administrative and marketing and development payroll, telephone bills, Internet access, all those things a business pays for but doesn’t resell are operating expenses. Taxes and interest are also expenses. Expenses include non-cash items, such as depreciation and amortization, but do not include payments that are not deductible from income, like dividends to shareholders or the repayment of the principal amount of a loan. The fact that the Profit and Loss Statement does not include some cash transfers (like the money the company gets when it borrows, or the money the company pays when it repays the principal of a loan) and the fact that the Profit and Loss Statement does include some deductions from profits that do not involve cash (like depreciation and amortization) is what differentiates the Profit and Loss Statement from the Cash Flow Statement.

Fixed and Variable Cost: A variable cost is a cost that changes depending on the number of goods your company produces or the amount of products or services your company sells. Examples of variable costs are raw materials used in making your product, direct labor (labor costs you only incur in making a sale, like an hourly rate job that you service by paying a subcontractor by the hour), shipping costs, sales commissions. Variable costs are those which you only incur if and when you make a sale today.  Fixed costs are those which do not vary by sale. They remain the same regardless of how much is sold (until you change them yourself by renting a bigger building, hiring more employees, etc.) Examples include the salaries of employees that are not directly tied to revenue – employees that are paid the same salary each month whether they sell more or less goods and services; rent and other overhead that is not included in cost of sales; phone service, insurance, utilities (your utilities might go up or down somewhat based on your sales volume, but the bulk of your utilities cost as not revenue dependent – the lights stay on and you heat or cool the office regardless of sales. For this reason, utilities are generally considered a fixed cost. Variable costs are generally booked as Costs of Sales, and Fixed Costs are booked after Gross Profit as Operating Expenses.

Break Even Analysis: Possibly the most important calculation the beginning entrepreneur will make is the break-even analysis. To make the break-even analysis, you must have a good handle on your fixed costs versus your variable costs. The break even analysis tells you what Gross Sales you must generate in order for your Net Profit to equal zero. In other words, how much revenue do you need to break even?

To calculate the break-even point, you have to first identify your variable expenses, and then calculate a cost per unit ratio: this is the average percentage of costs of sales per dollar of revenue. If you are a game store that resells games you purchase from distributors, and you generally mark your product up 100%, and you don’t pay commissions or have any other direct costs of sales, then your cost per unit is $.50/$1.00.  In other words, you make fifty cents Net Profit for every dollar of revenue.

Next, you must calculate your total fixed costs: how much are you paying each month (quarter, year) in fixed expenses that do not vary based on sales. Rent. Salaries. Utilities. Insurance. Phones. Interest. You are looking for a total dollar amount per period.

Finally, divide the total of your fixed costs by the Net Profit per dollar, and you will determine break-even revenue. (Break Even Revenue = Fixed Costs/Net Profit per Dollar).  If our game store has $10,000 per month in fixed costs, and earns $.50 per dollar in Net Revenue, the store’s break-even point of $20,000 per month in gross sales. Knowing this number is critical for your business, and you should not only try your best to calculate it before you open, you also should be refining it as you go.

Profits (and Losses). The “bottom line” of the Profit and Loss Statement is the Net Profit or Loss.  Simply put this is your total Sales minus Cost of Sales minus Expenses. If someone asks you, “what’s your bottom line”, this is your answer.

As an entrepreneur, you don’t need to be an accountant (although you should have an accountant). You must, however, understand basic finance and able to talk intelligently to shareholders, creditors, lenders, board members, and business partners about your company’s financial health. You must also be familiar with the basic financial tools you can use to measure and monitor your company’s financial help. Knowing these terms is a good start.

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One thought on “Debt to Equity Ratios and All That Jazz – An Entrepreneur’s Primer on Financial Statement Terms

  1. Pingback: Create Business Value Now – For a Successful Exit Later | On Business

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