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.