A business can finance its operations either through equity or debt.
Equity is cash paid into the business by investors who receive a share of the company, enabling them to receive a percentage of profits and appreciation in value. Conversely, debt is borrowing money from an outside source with the promise to return the principal, in addition to an agreed-upon interest level based on the risk being assumed, says Robert Olszewski, director at Kreischer Miller and leader of its distribution industry group.
“In a privately held company, investors have less ‘liquidity’ because the shares are not traded on the open market and a purchaser may be difficult to find,” Olszewski says. “This is one reason why successful and rapidly growing small businesses are under pressure by stockholders to ‘go public’ and thus create an easy way for investors to cash out.”
Smart Business spoke with Olszewski about how debt is interpreted by investors and what that means for your business.
What are the advantages of debt financing?
By borrowing from a financial institution or another source of funds, you are obligated to make the agreed-upon payments on time and to operate within specific financial covenants; this is the end of your obligation to the lender. A key advantage to debt is that you can run your business in accordance with your plan with limited outside interference.
How do owners maximize their return on investment?
Some leaders struggle with this concept early on, but over time, gain a better understanding of how it works. Simply put, if you have $5 million of equity invested in your business and the company generates $500,000 in profits, your return on equity is 10 percent.
Conversely, if you borrowed $2 million from the bank to invest elsewhere while maintaining $3 million in equity, your return on investment is now 16 percent. Granted there would be interest costs associated with the $2 million in debt. But you would still be ahead of the game at a 10 percent interest rate on the additional borrowing.
How do you know when enough is enough when it comes to debt?
Leverage ratios are often the measure of overall risk; debt-to-equity is the most common (total liabilities divided by shareholders equity). In general, a high debt-to-equity ratio indicates that a company may not be able to generate enough cash to satisfy its debt obligations.
However, low debt-to-equity ratios may also indicate that a company is not taking advantage of the increased profits that financial leverage may bring.
Lenders and investors usually prefer low leverage ratios because the lenders’ interests are better protected in the event of a business decline and the shareholders are more likely to receive at least some of their original investment back in the event of a liquidation. This is a common reason why high leverage ratios may prevent a company from attracting additional capital.
What if traditional debt is not an available option?
This is risky and may indicate that an owner is going too far. There are two common forms of alternative financing; equity based and mezzanine (each coming at an embedded cost).
Equity financing involves selling shares of your company to interested investors. Investors may also provide mezzanine financing which are debt instruments provided at significant interest costs (based on risk) and a provision to convert debt to equity.
Leverage in business is normal. The pros and cons directly correlate to the amounts and types of obligations that you are willing to incur. ●
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