The second important ratio the Business Owner should understand is the borrowing level in comparison to the capital & reserves in the books.

1. As we discussed in the earlier blog the balance sheet has been divided into 6 boxes for arriving at the character of each asset / liability.

 To recollect, we reproduce the box below

LIABILITY		ASSETS
Current Liability		Current Assets
Long Term Liability		Miscellaneous Assets
Share + Capital + Reserve		Fixed Assets

Total

Total

 

2. We are now analyzing only the liability side. Basically liabilities are the sources by which a business entity is able to raise the funds to deploy in the any one of the 3 Asset components as in the above table. Therefore, the source of funds plays an important role in determining the health of the balance sheet. The three major heads of sources, as per the table are

A = Current Liabilities

B = Long Term Liabilities

C = Share + Capital + Reserve

A + B is the amount received from others as loan, either short term or long term. It is to be paid as per the terms agreed upon. C is the Share Capital invested by the owner along with the retained profit earned over the years, (minus intangible assets)

Let us compare A+B with C

Assume, A+B = Rs. 300 lacs

                   C = Rs. 100 lacs

Total outside liabilities           300 TOL / TNW  = ------------------------------- =    ------   = 3      (Gearing)     Total tangible net worth.        100                     (Intangible Assets are reduced)

 

3. For a small scale manufacturing entity this ratio of 3 up to 4 is acceptable. If the ratio exceeds beyond this limit, the borrowings will be a strain due to debt servicing issues.
4. The profit before interest and depreciation will be eaten away by the interest. Further, loan ratio of 2:1 is even better where the risk of repaying and operating with outside funds are further reduced
5. Capital and reserves and reserve play an important role. The owners may find it difficult to bring the capital especially for sole proprietor and partnership entities over a period of time and growth. The entity should plan for a private limited company where share holders can participate.
6. The following are the advantages, when the capital is periodically brought into the business

• The improved capital gives room to raise further debt. Assuming if the capital is Rs. 100 then the outside liabilities can go up to Rs. 300. Whereas by addition Rs. 50 (as further infusion of capital) the outside liabilities can further raised 3 times

100: 300             150: 450

• When owner’s stake is good the lenders take a positive view.
• The lenders even offer better prices / rate of interest when they see a healthy TOL / TNW or gearing ratio.  

Example of how higher borrowings directly impact a business
	A	B
Share capital	100	50
Borrowing	300 (12%)	350 (12%)
Size of Balance Sheet	400	400
Interest cost per year	36	42
Profit before interest	50	50
Profit after interest	14	8
Profit Before Interest    % Total Capital employed	12.5%	12.5%
Profit after Interest          %  Total Capital employed	3.5%	0.5%

Effort of the business goes towards interest cost and therefore effective management of outside borrowing an important focus area.