Equity is a primary indicator of your business’s financial stability. If it is strong you can have more confidence in your financial capacity to navigate the ups and downs of business life. It represents the value that has been built up in the business through investment and profitable operations – so you need to protect it!
Equity is sometimes called Net Assets – Total Assets less Total Liabilities:
- Owner investment
- Operating losses
- Owner withdrawals
- Operating losses
Other parties are also interested in your business’s equity, and this is why:
Banks & Other Lenders
Your equity helps your bank decide whether to lend to you. If your equity is strong it means you have assets that they can use as security for financing such as a loan, invoice finance, trade finance, equipment finance.
When seeking unsecured financing such as an overdraft, your equity shows the bank your capacity to repay the loan, because you have income producing assets, a history of profits, or ideally both.
Investors examine what is driving your business’s profit – either strong customer relationships (goodwill) or by revenue generating assets. They then conduct due diligence to verify the real value of these assets.
Low equity is a red flag for investors. It can mean income generating assets are at the end of their useful lives and need to be replaced. If so they will reduce their offer because they will need to finance this future investment. It could also mean your lending is high which limits future expansion which will again reduce their offer.
How can I protect my business equity?
- Make sure assets are valued properly in the business financial statements. Often accountants will use tax valuations – for example if you bought new machinery that was eligible for a 100% tax write off, in the financial statements it should be written off over its useful life (not all in the first year).
- Set a limit on lending versus equity to fund your business. Monitor it by adding the Debt/Equity ratio to your management reports – your bank will appreciate this when you share your monthly/quarterly reports with them. A rule of thumb is maximum 1:1.5 (ie $1 debt for $1.50 equity) however this may be higher depending on your industry.
- Get commercial finance advice. Protect your business equity with specialist advice with a commercial focus.