Business

OPINION: Make debt a friend when creating business model

ESTABLISHING a profitable business model is obviously the key to any successful business. However, of equal importance is having a capital structure that matches it. By that I mean, having the right mix of debt and equity in your business.

Debt is a very valuable source of capital, because it:

  • Has a fixed return ("interest") which is lower than equity capital, thereby providing "leverage" by reducing the equity capital investors need to commit and improving their (positive) returns; and
  • Provides a tax deduction for interest, effectively discounting its cost.

However, debt also presents a risk because:

  • Unlike equity, which does not receive a guaranteed return, interest is a fixed cost which may not adjust in line with cash flow; and
  • Failure to honour debt obligations can lead to erosion of equity value and may result in bankruptcy.

Many people, whether it's buying a property or starting a business, will borrow as much debt as their broker can find for them for the acquisition, and then spend the ensuing months/years worrying about it until it is fully paid off. Because, of course, everyone's goal should be to be debt free, shouldn't it? Or should it?

Whether its your personal or business' balance sheet, debt is an important source of long term capital. However, due its characteristics, debt needs to be managed carefully and pro-actively.

Every household and business is different and the level of debt each is able to carry is also unique; depending on the volatility and predictability of its future cash flows. For instance, a construction company which has very lucrative but short term contracts, in a cyclical industry, should carry a smaller proportion of long term debt than a cleaning business with several 10 year government contracts.

While lenders may look at asset backing and alternative sources of cash flow (e.g guarantors) when determining how much they should lend, borrowers should base their decision entirely on the project's cash flows. At the early stages of a business, these cash flows are difficult to predict, so it pays to err on the side of caution.

As a business matures and its cash flows become more predictable, it may make sense to increase debt levels to release equity capital for other projects.

The type of debt is also important. Using long term debt for short term uses, and vice versa, can have disastrous consequences.

As far as possible, match your debt to its use. For instance, using credit lines or overdrafts for small, short term working capital needs can make sense if managed carefully. But don't kid yourself. If that working capital is really a long term liability, find another source of capital to fund it.

Regularly restructuring and refinancing debt, as part of capital budgeting, is what the CFOs of big business get paid six figure salaries to do because these companies see the enormous value in doing so.

* CAMPBELL KORFF is the principal of Yellow Brick Road Wealth Management, Northern Rivers.

Topics:  business, debt, money, tax




Stay Connected

Update your news preferences and get the latest news delivered to your inbox.

3 easy dinner recipes your kids will love, and so will you

No Caption

THERE is a middle ground! Dinners fit for kids and adults.

How to reduce your child's risk of food allergies

ABOUT 90% of food allergies are caused by just seven foods.

5 good mental health habits for kids (and parents)

CRYING OUT FOR HELP: The demand for counselling support for children and young people is increasing.

FORMING good habits early is critical for your child's mental health.

Smack or no smack - where do you stand?

THE debate is reignited - is smacking acceptable?

Susie O'Neill: Why I stopped smacking my children

Swimming legend Susie O'Neill says she has stopped smacking her kids.

“I (smacked) because that’s what I knew growing up."

Introducing a step-parent into the family

Introducing a step-parent into the family can be stressful for the children, as well as the new parent.

THERE is no easy way to introduce a step parent into the family.

Lismore barber reveals edge with old-school milk bar

Nostalgic owner Morgan O'Hara has installed an espresso and milk bar at his barbeshop in time for the Lantern Parade.

Short back and sides and a malt milkshake, please

25-year fight for wheelchair access ends with $400k funding

The Richmond River Historical Society has finally had a win in their fight for a museum elevator.

Historical Society's patient battle for wheelchair access pays off.

Latest deals and offers

Justice Lucy McCallum

Justice Lucy McCallum

Justice Lucy McCallum says she reduced Oliver Curtis's sentence due to comments...

$1 million cannabis seizure

Police discuss a huge cannabis seizure and the arrest of seven men.

Perisher has 50cm of snow

Resort to open after 50cm of snow.

Smiggin Holes and Blue Cow to open after 50cm of snaow falls in Perisher valley.

OPINION: Should we give up the great Aussie dream?

Generic housing Rural View.

First home buyers are struggling big time

Commercial Property June 16 edition

SNAPPED UP: A sushi shop in a106sq mground-floor tenancy with a 43sq moutdoor area in Southport Central Towers on the Gold Coast has sold for $954,000.

RealCommercial edition June 16, 2016.

Iconic North Coast hotel could sell for $80 million

ON THE MARKET: The Beach Hotel, Byron Bay.

Million-dollar views, good income, beer - what more could you want?