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Business Debt: Just How much is Too Much

It has been long held that while financial debt may have troubling ramifications for a business, it can be used to increase company value when properly and aggressively applied. On the one hand, choosing debt financing over equity financing can increase the personal and corporate tax benefits. On the other, there are hidden trade-offs when a business is highly leveraged, such as restricted flexibility in policy adoption, especially when the policies are more risky. This article discusses some of the most important questions to ask before deciding whether or not to use a debt facility or when establishing organizational debt policies.

Business Debt: Just How much is Too Much? : eAskme
Business Debt: Just How much is Too Much? : eAskme
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What’s the problem with debt?

Many companies are facing harder financial times because of global inflation that increases production costs and increased competition and hence reduced market share and revenues among other things. The result is that companies have increased their borrowing, some going as high as 3.5 times the amount of equity they have. This in turn has sharply increased the interest payable, decreasing the pre-tax profits being realized.

When the debt facilities are short-term, businesses face even bigger risks in terms of changing interest rates and increased refinancing risks. As inflation keeps rising, the need for external financing increases, meaning that businesses will have to give up current interests on low-cost debts when refinancing at the higher interest rates we have today.

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As such, top finance managers are in a difficult position, caught between the above scenario and operation managers who need funds to power marketing and/or production strategies to maintain or increase competitive advantage. There are companies, whose policies don’t provide for equity financing and are run mainly by operational management, which will have greater pressure to seek debt financing, compounding the problem. In reality, debt financing has a much smaller payoff than CFOs think.

Why is debt financing so appealing?

Debt has been known to have a positive effect on a business’s return on equity. There is a cost attached, however. For one, debt increases the fixed interest expense, shifting the breakeven point higher up the expected sales level. When sales revenues are lower, absolute profits are lower with debt financing compared with all-equity financing. When sales revenues are higher,absolute profits are also higher compared with equity financing. This volatility of earnings is something that investors follow closely. Traditional theory however assumes that debt is no problem provided its amount does not open up the possibility of insolvency. The idea is to achieve a balance between leveraging earnings without alerting investors of an increase in insolvency risk. When this balance is achieved, debt can be used to grow the business.

It has been postulated that in a world without transaction costs and taxes, debt financing would not impact company value in any way. In the presence of corporate taxation, however, going with debt financing ultimately raises the amount of funds distributable to investors (suppliers of capital) compared with equity financing. Since the cost of interest is typically tax-deductible, there’s a marginal subsidy provided and these funds are kept as part of business profits.

Questions to ask when establishinga Debt Policy

There are many points to consider before settling on the best debt-to-equity ratio for your company. The main responsibility of a CFO is to balance the company’s fiscal needs with its ability to get funds. The goal is to ensure there’s a continuous flow of funds so that no policy or program fails because the business lacks the financial ability to avail itself of the opportunity. This should happen regardless of external or internal upheaval, such as volatile capital markets or low revenue seasons.

It is the work of the CFO to always work to increase their range of financing options, relying on traditional suppliers of capital as well as other sources. In difficult times, the relationship established with financiers will increase chances of positive feedback when in the search for financing. A healthy company is one that is able to match its operational policies and strategic goals with its ability to access financing. To do this, the company should establish the following facts:

1.    The real financing needs

You should know how much money you may need to raise in the next, say, 3-5 years in order to meet your product, sales and marketing strategies (operational strategies). How long will you need the money for? Is it possible to defer the need without incurring a significant opportunity cost or organizational cost?

2.    Financing characteristics

Establish any special characteristics for your financing, such as maturities, prepayment or special takedown provisions, currencies,reviews, floating versus fixed rates, and provisions for renegotiation among others.

3.    Target sources

Establish the lending segments within the capital market that the business can turn to for all types of financing that is required.

4.    Lending criteria

Find out the lending criteria that all your target financing sources apply. Lenders differ considerably in their lending criteria and these will inform a preliminary capital structure for your company. The suitable debt level will be different for businesses according to the industry, sales volatility, management quality, profitability and competitive advantage among others. For instance, companies that have higher competitive risk may balance this by having low financial risk. In comparison, companies with low operational and competitive risks are freer to increase their debt ratios.
Practically, most companies’ target debt financing level is a level which allows them to maintain an A bond rating or higher. This is so because getting lower than an A rating reduces chances of being able to get funds from public bond markets affordably. In addition, companies are required to maintain financial reserves to cushion themselves from financial adversity.

5.    Repayment ability

The company should be able to meet all its debt obligations as stated in its standard financial statements, in both high and low revenue periods. In addition, the policy should allow flow of funds to strategically vital programs and policies even in hard times. This is the time to establish the highest risks you desire to protect your business from and any additional financing that would be required in the event that the risk materializes.

Conclusion

A single article cannot exhaust all the points to be considered when establishing a healthy debt policy for a working business in today’s environment. That being said, the most important point is to ensure a healthy reserve fund for periods of adversity. Aggressive application of debt may be hard to reverse in future, so you may be better off starting conservatively and increasing your risk as you increase your ability to manage it. At the end of the day, your business requires a steady stream of capital for operations and risk management – that is the summarized role of any finance manager/team.

Author Bio
Isabella Rossellini is a marketing and communication expert. She also serves as content developer with many years of experience. She has previously covered an extensive range of topics in her posts, including business debts consolidation and start-ups.