Understanding debt capitalisation and leverage

October 22nd, 2020

A guide to debt capitalisation and leverage, and the ways in which it can benefit your business

Not all debt is created equal, and many SME owners will need to learn that some types of debt can be a positive for your business.

We’ve discussed previously how much debt your business should have. So, now it’s time to dive deeper into the right kinds of debt your business can have to help it succeed.

With interest rates at historic lows in Australia, debt capitalisation and leverage ratios may be able to come in handy for many SMEs.

Leverage ratios and debt capitalisation explained

A leverage ratio is a financial measurement umbrella that can be used to express the indebtedness of a business.

There are a few leverage ratios that fall under this umbrella, with these being the 5 most popular:

    • Debt-to-Assets Ratio = Total Debt / Total Assets
    • Debt-to-Equity Ratio = Total Debt / Total Equity
    • Debt-to-Capitalisation Ratio = Today Debt / (Total Debt + Total Equity)
    • Debt-to-EBITDA Ratio = Total Debt / Earnings Before Interest Taxes Depreciation & Amortization (EBITDA)
    • Asset-to-Equity Ratio = Total Assets / Total Equity

While we know that too much debt can understandably be risky for your business and investors, some debt can actually be useful. In fact, a business can raise money by issuing debt to creditors or by using their debt for tax deductibles.

What SME owners will need to know to do so is the total debt-to-capitalisation ratio of their business. This is a tool that measures the amount of outstanding debt as a percentage of its total capital.

As expressed above, this is found by dividing the short-term, or “today’s” debt by the long-term “total” debt of a business + the total business equity. This is valuable, as the ratio is a gauge of the SMEs leverage, and showcases to analysts and investors whether or not it’s worth investing with your company.

In a period of low interest rates, debt can be a lot easier to manage for many businesses. In some cases, it can also be used to your advantage.

Case Study: Apple’s debt success

To get a better understanding of what this means for your business, let’s consider Apple as an example.

You’d be hard pressed to find anyone who was unaware of Apple and at least some of the tech behemoth’s success story. Co-founded in 1976 by Steve Jobs, Ronald Wayne and Steve Wozniak in Jobs’ parents’ home in California, it has exploded into a globally dynamic and influential technological powerhouse, worth over $1.3 trillion.

How much equity and debt a company is able to take advantage of is also known as capital structure. Apple’s capital structure is a fascinating deep dive into how a business is able to use debt to its advantage.

In 2013, interest rates in America were at record lows thanks to the Global Financial Crisis. Due to the zero interest-rate policy environment (ZIRP), Apple was able to underwrite a total of $64.46 billion worth of debt by issuing its first bonds and notes.

Issuing bonds is one way a company can raise money as it functions like a loan between an investor and a business. The company receives the agreed upon money, and the investor is paid periodically in interest. When the bond reaches maturity, the company will repay the investor.

Apple did not necessarily need the capital, but in fact, understood that by issuing these bonds and notes at such low interest rates it was essentially getting money for free.

This process changed Apple’s capital structure for good. It’s current and quick ratios have risen by 33% and 59%, respectively, in the last 5 years, according to analysis by Investopedia.

In terms of leverage ratios, Apple's debt-to-equity ratio jumped from 5% in 2016 to 112% as of 2019. As of June 29, 2019, Apple’s current liabilities were $89.7 billion, consisting of $29.1 billion in accounts payable $13.5 billion in short-term notes and bonds, according to Investopedia. Long-term debt and other non-current liabilities amount to $136 billion, bringing Apple’s total liabilities to $225.8 billion, an increase of nearly 63% in the last 3 years.

More ways debt can help your business

Now we’ve discussed debt capitalisation and what your company’s leverage ratios are, here are some more ways that debt may be able to help your business, rather than hinder it:

  1. Debt can keep the ball rolling. Many businesses need debt in the form of invoice finance, lines of credit or bank loans when faced with rapid growth early on. This can help them to maintain that same pace and maintain a positive cash flow.
  2. Government-backed business loans. There are a range of reduced rate government-backed loans that may be available to your business. Currently, the Coronavirus SME Guarantee Scheme may be worth looking into.
  3. Reduces your risk of insolvency. Borrowing small, manageable funds from a variety of sources can help to reduce the risk of not being able to meet your repayments or manage your overheads. Particularly if you are borrowing against your accounts receivable, as with an invoice financing facility. This sort of debt also helps to lower any risk to your assets.
  4. Improves your creditworthiness. Just like with your own personal credit score, paying back a debt to a big bank can help to position your business favourably, as it shows that you are reliable with your finances. It may also mean you are more likely to be approved for further financing, and will pay lower rates in the future.

If you think that your business can benefit from Earlypay's modern invoice discounting facility and would like to find out more, please get in touch with our friendly team today on 1300 760 205.

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