Reader asks: “What’s the 40-60 equity rule?”

chart_40-60

Question:

I went to a bank recently to inquire about a business loan. I was asked how much I wanted to borrow and was told that I should observe the “40:60 equity rule.”  The bank officer sounded as though I should know about it.  So I simply told him I would check and walked out.

Please explain this rule to me in plain language.

Thank you.  And thank you for your articles that I have found useful as I struggle in this business which I began six months ago. ( I read all the articles in Beginner’s Tool Kit.)

Benji Lopez, Manila

Answer

The 40-60 debt-equity ratio is often held to be the ideal financial structure for any business to be healthy.

What does this ratio mean?

It means that your business must be financed by only 40 per cent debt (what your borrow) and 60 per cent equity (your own contributions).

For example, if you need Php 100,000 to finance your business, only P40,000 should be borrowed and the rest or Php 60,0000 must be your own equity.

This 40-60 ratio is recommended in order to:

  • Provide for future borrowings when the business will expand, or
  • Meet changing circumstances and situations.

You see, most banks and other financial institutions will allow you to borrow only if the resulting debt-equity ratio (after borrowing) is 40 per cent debt and 60 per cent equity or lower. Firms with higher debt-equity ratio are saddled with high loan and interest payments.  This situation puts these businesses at a disadvantage especially when they compete with other businesses without a similar debt burden.

In other words, banks are concerned about this ratio because it measures your capacity to borrow and repay loans.

Since we’re talking about business loans and a business’ financial health, let me give you more borrowing rules to follow to assure that the loan you take will work for your business rather than get it into more financial trouble:

  • Fixed assets and working capital requirements during normal operations must be financed from long-term loans (or your own equity).
  • Short-term requirements, like additional working capital needed during peak season (Christmas, school opening and other special occasions) must be funded from sources that offer short-term loans, like:  trade credits (30,60,90 days), short-term bank loans (two or three months), pawnshops (three months), friends, relatives, and family members.

In short, short-term capital requirements must be financed by short-term loans.  Long-term capital requirements must be financed by owner’s equity and/or long-term loans.

I hope this helps.  Good luck in your borrowing and good health to your business!

 

 

 

 

 

 

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