How can a company manage its debt-to-equity ratio to attract investors?

In 2024, corporate bankruptcy filings in the US rose to a 14-year high, making debt management a top concern for investors. Before committing capital, investors scrutinize a company’s debt-to-equity ratio to assess financial risk. To maintain a good debt-to-equity ratio, businesses must adopt strategic measures such as restructuring debt, increasing profit retention, and negotiating favorable loan terms.

In this article, we will explore key metrics for evaluating the impact of debt, effective repayment strategies, and financial optimization techniques to help you build a debt structure that attracts investors.

Assessing your company’s risk from debt in the right way

Before you make any significant changes to your business’s financial structure and strategy, you must first understand how debt is affecting the company’s financial position. This means identifying the right metrics to measure its effect and determining a healthy debt level for your organization.

Debt-to-equity ratio is a balance sheet metric that is often used to judge the financial strength of established corporations. However, a startup whose debt dynamics would change significantly after funding rounds may benefit from reviewing its debt health through cash flow-related metrics, which could be:

Cash interest coverage

Cash interest coverage is calculated by dividing the earnings before interest, tax, depreciation, and EBITDA or some other relevant cash flow metric by the interest payments in that period. This metric allows a business to gain a deeper understanding of its liquidity needs.

Debt-to-EBITDA ratio

The debt-to-EBITDA ratio helps a business understand how many years of EBITDA would be needed to pay off debt. For a startup heading into a funding round, projected debt-to-EBITDA while scaling, as well as post successfully scaling, can be more important from the perspective of a venture capital investor.

Can you repay the debt?

Repaying debt directly changes your debt-to-equity ratio and, hence, it is the first approach any business considers to bring its debt to a healthy level. You can repay debt either through equity financing or by digging into your cash reserves.

Let us explore both alternatives here.

Repaying debt through equity financing

When a business has a high growth potential but the only thing that is holding it back is its debt, then raising equity to simply pay out long-term outstanding debt can be viable. Consider the following scenario from an investor’s perspective.

Navarone is a travel and accommodation booking company with a valuation of $5 million, and its unlevered free cash flows are as follows.

Period	2025A	2026P	2027P	2028P	2029P	2030P
Earnings before interest, taxes, depreciation, and amortization (EBITDA)	$1,250,380.00	$1,562,975.00	$1,953,718.75	$2,442,148.44	$3,052,685.55	$3,815,856.93
Depreciation and amortization (D&A)	$118,000.00	$125,080.00	$132,584.80	$140,539.89	$148,972.28	$157,910.62
Earnings before interest and taxes (EBIT)	$1,132,380.00	$1,437,895.00	$1,821,133.95	$2,301,608.55	$2,903,713.27	$3,657,946.32
Tax rate	21%	21%	21%	21%	21%	21%
Tax	$237,799.80	$301,957.95	$382,438.13	$483,337.80	$609,779.79	$768,168.73
Earnings before interest (EBIT - T)	$894,580.20	$1,135,937.05	$1,438,695.82	$1,818,270.75	$2,293,933.48	$2,889,777.59
Depreciation and amortization (D&A)	$118,000.00	$125,080.00	$132,584.80	$140,539.89	$148,972.28	$157,910.62
Net working capital	$1,032.40	$929.16	$836.24	$752.62	$677.36	$609.62
Capital expenditures	$9,835.70	$10,425.84	$11,051.39	$11,714.48	$12,417.34	$13,162.39
Unlevered free cash flows (UFCF)	$1,001,712.10	$1,249,662.05	$1,559,392.98	$1,946,343.55	$2,429,811.06	$3,033,916.20

When we discount the unlevered free cash flows (UCFC), which are operational cash flows before debt or interest payments, at a discount rate of 20%, we arrive at a net present value of $9.52 million. However, the business valuation is being reported as just $5 million. This means that despite the EBITDA growing at 25% annually, much of the value is being captured by creditors.

Such a company can be a good investment opportunity, even if no major changes are made in terms of expansion or introduction of new products.

Repaying debt through cash reserves

Let us continue our example and see if it is viable for Navarone to repay debt through its cash reserves. For this purpose, let us consider its current assets and liabilities.

Current liabilities	Amount	Current assets	Amount
Payables	$60,000.00	Cash	$225,000.00
Short-term liabilities	$203,967.60	Receivables	$40,000.00
		Inventory	$0.00
Net working capital	$1,032.40	-	-
Total	$265,000.00	Total	$265,000.00

Given the fact that Navarone has a very low net working capital, if it uses its cash reserves to pay off debt, its operations will suffer due to working capital constraints. The company’s $40,000 in receivables could help improve liquidity, but only if the turnover is fast. Otherwise, it cannot be relied upon to meet debt obligations.

We must also note that the company’s cash reserves are barely enough to repay short-term liabilities. Given how much of the value generated is being captured by creditors, the company must also have significant long-term debt. So, debt repayment through cash reserves is extremely risky due to liquidity constraints and completely unviable for long-term debt.

Note: If a company can repay its debt without experiencing working capital difficulties, it should definitely consider that option. A company must identify the cash buffer that ensures smooth operations and then figure out if it will have enough left over after repaying all debt.

How can you optimize your debt-to-equity ratio by improving your financial strategy?

Optimizing your financial strategy can improve your business’s debt-to-equity ratio in the long term. The key steps to do so are as follows.

Be deliberate about short-term debt

Due to the digital revolution and progressive reforms in the financial services industry, short-term loans have become widely available in various forms. As a result, more businesses are relying on short-term debt to meet working capital requirements.

However, their easy accessibility does not always make them the best option, as they often come with high interest rates. Businesses should use credit strategically and consider lower-cost alternatives such as supplier credit or structured trade finance to minimize borrowing costs.

Increase profit retention

When you retain profits, your equity capital increases, which can directly improve your debt-to-equity ratio. These profits can either be invested in new assets or added to the cash reserves. New assets would increase your production capacity or cost economics, while higher cash reserves will improve your working capital efficiency.

In the long run, this will increase the possibility and scale of profits and improve your debt repayment capacity.

Negotiate loan terms for favorable prepayment

If you choose a lender that allows prepayment without penalties, you can take out loans with longer tenures. This will ensure that your monthly payments are lower. Then, whenever your financial condition allows for it, you can make prepayments to reduce your principal amount, which in turn reduces interest payments in the long term.

This strategy makes repayments more manageable while also providing the flexibility to aggressively reduce debt.

How should you restructure debt to attract investors?

From an investor’s perspective, a company’s debt appears manageable if the free cash flow to equity is not heavily impacted by loan payments. So, if reducing debt directly is not feasible, you must focus on lowering monthly payments by adjusting interest rates or loan tenure.

If restructuring in the traditional sense is not possible, you should consider debt-to-equity conversions. Most traditional banks will resist this due to their liquidity constraints. However, venture capital lenders are often more open to this idea. If you have borrowed primarily from traditional banks, negotiating a transition to lenders that also hold equity could be beneficial.

Eqvista – Empowering your visions through actionable insights!

Improving your financial strength through debt management to improve your debt-to-equity ratio often requires long-term strategies that take effect in at least a year. While your efforts to improve your debt-to-equity ratio will not be entirely wasted, they will fall short of being impactful in changing the narrative in fundraising efforts. Hence, you must also focus on other areas, such as researching expansion opportunities and experimenting with scaling ideas to add weight to your growth potential claims.

The insights in Eqvista’s valuation reports can not only help you identify such opportunities but also assist in negotiating a higher valuation. Contact us to know more!