When it comes to our own finances we typically see debt as a negative but the reality is more nuanced.

Most of us would not have been able to purchase a home without a mortgage and yet running up unpaid bills on credit cards could leave you swamped in interest payments.

For businesses too, the use of debt is a balancing act and in this article we will look at the role borrowings play on a corporate level and the factors investors should keep tabs on.

WHY BORROW MONEY IN THE FIRST PLACE?

Fictional company Face Easy manufactures and sells face coverings and operates from a small warehouse. To meet strong demand the owners decide to purchase a new machine.

Face Easy shareholders have so far provided all of the money to set up the firm and run operations and are contemplating either bringing in outside shareholders to provide the funds or go to the bank. Most of the owners have spent all of their available cash on
the business.

The first option means that new shares would be created and the current owners would see their collective percentage ownership fall, also known as dilution, unless they could somehow find the cash to contribute to the equity raise.

The second option involves obtaining a bank loan and the bank decides to loan Face Easy the cash they need on the proviso that the company puts up the warehouse as collateral. This means that in the event of the loan not being paid back on time, the bank would take ownership of the warehouse and potentially the business.

The cost of losing a piece of the company after all the hard work seemed like an unattractive option to the owners. After all they estimated that the loan could be paid back in under five years given current demand and profitability.

THE ADVANTAGES OF USING DEBT

After speaking with their accountant they discovered there are some financial benefits to taking on some debts. For starters, bank interest is deducted from operating profit which means paying lower taxes.

This in turn increases the return on equity (ROE). Think of ROE as the interest rate that shareholders receive on their investment. It is calculated by dividing net income into the book value of equity.

The owners estimated that once the new machine was operating at full capacity it would add around 20% to potential sales, most of which would fall to the profit line because there were very few extra costs involved with selling more product as it was all done online. This is known as operating leverage.

The trade off here is between keeping all the extra future profits generated by the investment minus the interest costs versus not paying interest costs at all and only keeping say 95% of future profits because of the dilution effect.

Another advantage of debt is the current low cost of finance which reflects the fact that UK interest rates are almost zero. In Face Easy’s case the bank wanted to charge the company 5% annual interest.

DISADVANTAGES OF USING DEBT

Debt becomes a problem if a business experiences a downturn and it has so much debt that cash flows aren’t high enough to keep making the interest payments to the bank.

Even where a company makes an operating profit, subtracting interest costs can sometimes push the overall business into a loss making situation, which makes banks nervous.

Measuring the level of gearing in a company is one way to assess the situation. Gearing is usually calculated by comparing debt to equity.

Using Face Easy as an example, let’s assume the debt is £5 million and the equity is £30 million, dividing one into the other gives a gearing ratio of 16.6%, which is considered very low gearing.

Any ratio below 50% is considered moderate but once it moves above 50% it gets progressively more risky. Higher gearing means higher debt costs as banks demand increased rates of interest to compensate for the extra financial risk.

Large publicly traded companies that regularly issue debt have credit rating analysts providing credit research designed to assess the creditworthiness of the company for the benefit of debt and bondholders. Bonds are debt instruments that represent a loan made by an investor.

The safest credit rating is known as an investment grade rating and means that the borrower is very likely to pay back its loans.

Investment grade is usually defined as having a net debt to EBITDA (earnings before interest, taxes, depreciation and amortisation) ratio below 2.5 times, but this can vary depending on the industry and visibility of cash flows.

FIND THE RIGHT BALANCE

In practice having some debt is a good thing for shareholders for all the reasons touched upon but like a lot of things in life, using debt in moderation is always better than going overboard and prudence should always take precedence.

Generally speaking debt finance costs less than equity finance, although calculating the cost of equity isn’t as straightforward.

Think of the cost of equity as the expected return that prospective investors require compensating them for the risk of owning the shares. For most large quoted companies this is between 6% to 9%. In comparison the highest quality corporate debt yields are around 2.3%.

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