Assessing your company’s financial risk

An entrepreneur can fund the start or growth of his business through equity or debt or through a combination of debt and equity. Each of these approaches offer some advantages and disadvantages. Choosing which source of financing to follow is one of the critical choices a business owner or manager has to make. Steve Jefferson wrote in Pacific Business News (Jefferson, 2001), “The way that money is raised can have an enormous impact on the success of a business.”

Financing the business using debt involves the business having to take a loan or loans that will have to be repaid over time, usually with interest.
The loan could be for short term (less than one year) or long term (for more than one year). The advantage of using debt financing is that it offers the company a tax advantage, since the interest paid on loans is usually tax deductible.

Debt financing also limits dilution of business ownership since lenders don’t have a claim on the ownership of the business. However, debt financing can have serious implications on the success of a business.
A new business which usually has erratic cash flows during inception and is also very vulnerable to economic turbulence might find it difficult to make regular loan repayments.
A business with a high level of debt is very risky and is of concern to potential investors and therefore will find it very difficult to raise additional capital.

The other mode of financing that business owners could adopt is equity financing which involves obtaining financing from investors in exchange for ownership of the business.
The main advantage to equity financing is that it does not burden the business with having to repay the investors. The investors however have a claim of the future profits of the business.
The other advantage is that having well renowned investors in the company raises the profile of the business. Equity financing however has its own disadvantages. The main disadvantage is that the investors become part-owners of the business, and therefore have a say in business decisions.

Most businesses tend to use a combination of debt and equity. Business leaders have to decide how much of each to use. The decision on how much of debt or equity to use depends mostly on the long-term goals of the business and how much control of the business you need.
Investors are very interested in assessing the risk of the business with respect to how it’s funded. Managers or owners of businesses should track financial risk using the same ratios that investors will use.
Investors are mostly interested in separating companies with a healthy amount of debt from those that have too much debt. Too much debt might result in a company opting for bankruptcy when it cannot service its debt.

The ratios used in assessing financial risk are referred to as coverage ratios and include ratios such as debt to equity ratio (commonly referred to as gearing ratio), interest cover, debt-service and asset coverage ratios. These ratios will be discussed below.
The debt to equity ratio assesses how much a business is being financed from debt. It is calculated by dividing debt by equity. Business experts suggest that ideally a business should use both debt and equity financing, albeit within a certain commercially acceptable ratio.

The debt to equity ratio varies depending on the type of industry and also between companies. An acceptable ratio should fall between 1:1 and 1:2. It is advisable that companies should rely more on equity financing during the early stages of their existence, since during these stages the cash flows are very irregular and as such the business may find it difficult to service the debt.
The second ratio to assess financial risk is interest coverage ratio. Interest coverage ratio is computed by dividing earnings before interest and tax by the interest expense. The main objective behind this ratio is to assess the ability of a company to pay its interest from its profits.

A ratio above one means that the company can service its interest expense. Investors will be comfortable with companies that have an interest coverage ratio of at least 1.5, any lower figure will indicate a company that is struggling to pay off its lenders.
The third ratio to use to assess risk is the debt-service coverage ratio. This ratio is better than the interest coverage ratio because businesses should be able to cover interest expense and at the same time will have to pay part of the principal amount of the loan.

The debt service coverage ratio is calculated by dividing net earnings by the total of principal repayments plus the interest expense.
If the ratio is below one then the business has negative cash flow, that is, it cannot meet its borrowing obligations as they fall due.
Investors usually use coverage ratios firstly to track changes in the company’s debt situation over time. Any continuous decline in the ratios below the acceptable figures should raise alarm as to the future survival of the business. One can also use the coverage ratios when comparing the company with its competitors.

If the coverage ratios of a company are bad compared to the competitors then it should indicate that there could be a problem. Investors will then be wary of investing in such a company.
In business the caveat is “excessive reliance on debt can wreak havoc on a business” as warned by Proverbs 22:7 which says “The rich rule over the poor, and the borrower is a slave to the lender.”
It’s therefore very important for business leaders to use the above ratios to assess whether a company will be able to pay its lenders on time.

l Stewart Jakarasi is a business and financial strategist and a lecturer in business strategy (ACCA P3), advanced performance management (P5) and entrepreneurship.
He is the Managing Consultant of Shekina Consulting (Pty) Ltd and provides advisory and guidance on leadership, strategy and execution, corporate governance, preparation of business plans, tender documents and on how to build and sustain high-performing organisations.
For assistance in implementing some of the concepts discussed in these articles please contact him on the following contacts: sjakarasi@gmail.com, call on +266 58881062 or WhatsApp +266 62110062 .