When a business trades or wants to grow, sometimes it is necessary for a company to borrow and take on company debt but what effect does it have on a business?
Company debt generally refers to something owed by the business, who is the borrower or debtor, to a second party, who is the lender or creditor. Debt is generally written up in contractual terms (loan contract) stating the amount and timing of repayments of principal and interest.
How Does a Company Borrow Money?
There are 2 main different types of debt that a company can take on.
1. By issuing fixed-income (debt) securities – like bonds, notes, bills and corporate papers
Debt securities issued by the company are purchased by investors. When you buy any type of fixed-income security, you are lending money to a business or government. The issuing company must pay underwriting fees. However, debt securities allow the company to raise more money and to borrow for longer durations than loans typically allow.
2. By taking out a loan at a bank or lending institution.
Borrowing from a private entity means going to a bank for a loan or a line of credit. Companies will commonly have open lines of credit from which they may draw to meet their cash requirements of day-to-day activities. The loan a company borrows from an institution may be used to pay the company payrolls, buy inventories and new equipment, or keep as a safety net. For the most part, loans require repayment in a shorter time period than most fixed-income securities.
Companies typically fund their operations by a mix of debt and equity, which is like home ownership. With a mortgage, the bank is funding part of the house (debt) and you are funding the rest (equity). But that’s where the similarity ends, because unlike a mortgage, business debt is not always a bad thing. Used well, debt it can boost a company’s return on equity (ROE) – the return shareholders receive on their part of the funding equation – because debt is typically a cheaper form of funding than money supplied by shareholders (equity).
It is important that management gets the debt/equity mix right. Too much debt can place a company in a tight situation when business conditions go down, because, unlike shareholders, lenders demand to be paid in bad times as well as good.
Mixing debt and equity
What is the best mix of debt and equity? Investment guru Ben Graham used to say that a company should own more than it owes. One commonly used ratio to measure that is called the debt-to-equity ratio. It quantifies the relative proportion of debt and equity used to fund a company’s operations. Taking this back to Graham’s rule of thumb, that a company should “own more than it owes”, this is the case when the net debt-to equity ratio is below 1. It can also be expressed as a percentage, in which case you would be looking for a figure below 100 per cent. Warren Buffet prefers no or little debt.
Things to look for –
An investor should look for a few obvious things when deciding whether to continue his or her investment in a company that is taking on new debt. Here are some questions to ask –
Current debt the company has already?
If a company has no debt, then taking on some debt may be beneficial because it can give the company more opportunity to reinvest resources into its operations. However, if the company already has a substantial debt amount, be aware that too much debt is a bad thing because it inhibits a company’s ability to create a cash surplus.
Kind of debt is the company taking on?
Loans and fixed-income securities that a company issues differ in their maturity dates -within a few days of issue, while others don’t need to be paid for several years. Usually, debt securities issued to the public (investors) will have longer maturities than the loans offered by private institutions (banks). Large short-term loans can be harder for companies to repay, as can long-term fixed-income securities with high interest rates may not be easier on the company.
Debt to be used for?
Is the debt a company is taking on, meant to repay or refinance old debts, or is it for new projects with the potential to increase revenues? A company that must refinance existing debt may be doing so because it is spending more than it is making (expenses are exceeding revenues). But it is a good idea for companies to refinance their debt to lower their interest rates.
Can the company afford the debt?
Not all companies succeed in making the ideas work. It is important that you determine whether the company can still make its payments if it gets into trouble or its projects fail. You should look to see if the company’s cash flows are sufficient to meet its debt obligations. And make sure the company has diversified its revenue sources.
How does the company’s new debt compare to its industry?
Many different fundamental analysis ratios can help you along the way. The following ratios are a good way to compare companies within the same industry –
- Current ratio – This ratio indicates the amount of short-term assets versus short-term liabilities. The greater the short-term assets compared to liabilities, the better off the company is in paying off its short-term debts.
- Quick Ratio (Acid Test) – This ratio is the Current Ratio with stock/inventory removed – it tells investors approximately how capable the company is of paying off all its short-term debt without having to sell any inventory.
- Debt-to-Equity Ratio – This measures a company’s financial leverage calculated by dividing long-term debt by shareholders’ equity. It indicates what proportions of equity and debt the company is using to finance its assets.
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