In the past, debt wasn’t something that SaaS and recurring revenue businesses had to think about at the start up stage or while they were still relatively new. Even now, many startups choose to grow without taking on debt and instead focus purely on equity. As alternative forms of financing have become more available for SaaS and recurring revenue businesses, however, assessing the amount of debt held by a company and what that tells us about their financial health, has become more important. While most financing companies will look at a wide range of metrics, it’s useful to understand each one and what it can tell you about your financial health, before you approach a potential lender or investor.
We breakdown what the debt to asset ratio is and how SaaS and recurring revenue businesses can calculate that and use it as they’re looking for financing.
It’s important for businesses to calculate their debt to assets ratio, also known as the debt ratio, so that they understand the impact of debt upon their business. This ratio reflects the proportion of a company that is funded by debt rather than equity.
The classic formula for a debt to total assets ratio calculator is:
Debt to asset ratio = total debts/total assets
So, for example, if your total debts are $500,000 and your total assets are $1,000,000, then your debt to asset ratio equals 0.5.
If you prefer, you can express this as a percentage by multiplying the ratio by 100. In the above example, that would mean that this company finances its assets with 50% debt and 50% equity.
Not everyone treats ‘total’ debts or ‘total’ assets the same way, however, and so it’s important to understand how and why you can include or exclude certain items from these terms. It’s also key to use the same formula each year you calculate your debt to assets ratio if you want to do an analysis over time.
When deciding what to include as total debts and total assets, there are a few standard items from the balance sheet some analysts choose to include or exclude.
Total Debt: most include all interest-bearing short term and long term debts. Some other analysts consider including a variety of other liabilities other than common shareholders capital.
Total Assets: most analysts include current assets and noncurrent assets. Some may question whether to include cash, goodwill, or intangibles in this part of the calculation.
The debt assets ratio allows you to forecast whether your business will have the ability to pay off all its debt if it were required to do so immediately. If your debt to total assets ratio is under 1, for example, then that means that you could pay off all your debts with your current assets and still be left with money to continue to fund your business. If your ratio is exactly 1, that means it would take all your available assets to pay off your current debt, and therefore the business would not be able to fund anything else. If your ratio is above 1, that means you do not currently have enough assets to pay off all your debts if they became due immediately. Therefore you would have to default on some of your debt.
A potential investor or lender would want to know your debt to asset ratio as part of the process of evaluating your financial health. A ratio below 1 generally suggests that your company has used equity funding to date. Lenders will want to see a low ratio if they’re considering offering you debt financing, and the risk (and therefore cost) of obtaining financing is likely to increase the closer to 1 your ratio gets.
There are a number of ballpark estimates floating around about what is a ‘good’ or ‘bad’ debt to asset ratio. A rule of thumb in the past has been that a debt to asset ratio over 0.5 is where risks start to ramp up, and lenders may be wary. But the debt to asset ratio, by definition, depends on the types of debt (and assets) that are normal in any particular industry. In a traditional product-based business, there are often a lot of physical assets to balance out the debt. This is why product-based businesses traditionally obtain bank financing relatively early in their maturity. SaaS and recurring revenue businesses who don’t hold many physical assets, can find that their debt to total assets ratio becomes ‘risky’ almost as soon as they start to move away from equity funding and look at debt.
Ready ratios suggests that, for the category of business services the median ratio is 0.61 for 2021. It’s unclear exactly which industries and niches are included in that category, but it’s likely it would include SaaS companies. As there are over 1200 businesses in this category, it would probably be more relevant for you to identify a smaller and more relevant pool of companies to benchmark yourself against, but this gives a good starting point.
Because of the general lack of physical assets in this category, it’s unsurprising that this ratio is higher than for agricultural production, for example (0.43) or for the passenger transportation industry (0.27).
Debt to asset ratio is just one of a number of metrics that investors or financial institutions would look at when considering providing financing to a company. For example, the debt to asset ratio may be high if the company has intentionally taken out debt in an effort to fund growth.
Analyzing the debt to asset ratio over a period of years, together with other KPIs, would allow a potential investor or lender to analyze how stable a company is, and understand what they’re using debt for. If a company has consistently paid off any debt without defaulting, and has taken on more debt with a plan for exponential growth, with metrics that back that up, then a financial company may well still decide to invest or lend despite the debt to asset ratio being high.
Many alternative financing options are popping up now that are tailored specifically to industries and niches that normally couldn’t access non-dilutive options at a startup or early stage. The companies that look to fund these take a careful look at a number of metrics, and analyze these in light of the benchmarks for that niche. They also usually look at a wide variety of metrics so they understand the full story of how the business is funded and how it’s growing. The more metrics you can understand in relation to your business, your niche, and your growth, the easier it will be for you to make your case for obtaining financing.
If you’re interested in learning more about how Capchase supports SaaS companies, check out: Capchase.com/Grow.