Financial Funding Ratios
Another set of ratios we can use is what I call the Financial Funding Ratios.
Equity Funding and the Liability Funding Ratios show who funds a company’s operations. Remember a balance sheet summarises what a company owns (assets) and how it financed the purchases (Liabilities and Equity). The ratios indicate whether a company finances its operations with its own resources (equity) or other parties’ resources (liabilities).
Remember: Total Assets = Total Liabilities and Total Shareholders Equity
Therefore the two ratios add to 100%.
If most of the funding has been financed by a company’s owners the Equity Funding Ratio will be closer to 100%. A high Equity funding ratio can result from the owner A) the owner(s) initial high upfront investment and/or B) Retaining profit in the business as it builds the shareholder equity balance.
If a company is funded primarily through liabilities, it will have a higher Liability Funding ratio, and thus lower Equity funding ratio. Third parties can fund operations by A) Banks via debt, B) Suppliers through accounts payable, C) Employees via salaries payable, or D) Customers via deferred revenue.
In Finance, we refer to the breakdown in funding as the “Capital Structure“ of a business.
Look at the illustration of two balance sheets above.
The first balance sheet shows funding is split 75% Equity, 25% Liabilities:
- Equity Funding Ratio = 150 ÷ 200 = 75%
and - Liability Funding Ratio = 50 ÷ 200 = 25%
The first balance sheet shows funding is split 50% Equity, and 50% Liabilities:
- Equity Funding Ratio = 100 ÷ 200 = 50%
and - Liability Funding Ratio = 100 ÷ 200 = 50%
Generally, if a company is majority liabilities funded then debt will generally be a large part of the liability balance. However, if debt is a small part of total liabilities, and the liabilities fund ratio is still high it means that a large part of your funding is coming from a combination of suppliers, customers, or employees. This is very advantageous as an owner because these liabilities generally contain much less risk. Other third-parties begin to fund your operations by just by nature of the business you are in. This concept is related to float which we covered in the Balance Sheet Breakdown.
Let’s do the calculation with West Pharmaceuticals’ balance sheet.
We can see that West Pharmaceuticals is “conservatively capitalized” with a majority of their funding coming from shareholder equity, or the shareholders’ (owners’) investment.
The Aim
One shouldn’t think that goal is for a business to have the lowest possible liabilities funding ratio, and therefore highest equity funding as close to 100% as one can. As a business owner, you are trying to maximise the return on your investment per unit of risk taken.
Generating the same, or more, profit with other peoples capital (therefore a higher Liability Funding Ratio) improves the ROI for the owner of the business – Same, or more profit, on the same equity invested in a company by the owner. Increasing liabilities however, specifically debt, increases the overall risk a business holds in the capital structure. Balancing equity and liabilities to maximise ROI per unit of risk taken is called “Capital Structure Optimisation”.
Capital structure optimisation is very delicate and requires intense study a company’s of cashflow, and the consistency of cashflow. If revenue, and profit is very volatile it is very difficult and risky to have liabilities make up a big portion of your capital structure.
Pitfalls Of Funding Ratios
Funding ratios give us an idea about how operations are funded. If liabilities contribute a majority of the financing, we can conclude that there is likely more risk in the business. However, the these ratios shouldn’t be looked at in isolation. For example, if a company has liabilities funding ratio of 90% but its solvency ratios (e.g. Net Debt to EBITDA) are less than 0.5x we can likely conclude the business is not in danger of being over leveraged.
Conclusion
From the funding ratios, you as the owner can better see who is financing the business. We can use these ratios as diagnostic tests to derive information about or business. We can also see them as instructive. How can we change to business’ ROI per unit of risk.