The way you finance your business can have a significant impact on your wealth, and that of your co-owners.
How so? The two biggies are:
Return: Use of debt raises return on investment for the owner of a profitable company. For certain companies, the difference can be substantial.
Risk: Use of debt raises risk of insolvency.
As a business owner, you should understand these and make rational decisions about how you finance your business. This entails periodically assessing the business’ unique characteristics, prevailing costs of debt and equity capital, owners’ risk tolerance, and then selecting an appropriate capital structure (i.e., mix of interest-bearing debt and equity).
By way of background, a business is simply a compilation of assets and inputs that generate revenue and – if profitably deployed – profit. Typical assets are cash, inventory, marketing materials, equipment, furniture, fixtures, vehicles, customer databases, recipes, formulas, etc. Add to this the labor and know-how of employees – contributed toward production, sales and administration – and you have a business. For a going concern selling on terms, you also have accounts receivable. None of this has anything to do with debt or equity capital, except that these assets don’t just appear – they must be purchased. They can be purchased with equity contributed by the business’ owners (i.e., no repayment terms but simply ownership in the business) or borrowed funds (i.e., debt).
To demonstrate how debt can raise the rate of return earned by a company’s owners, let’s take two companies identical in every respect except their level of debt. Both earn $250 annually in EBIT (earnings before interest and taxes) and have $1,000 of assets. But Company A has $250 in trade debt, no interest-bearing debt and $750 of equity.
Company B has $250 of trade debt, $500 in interest-bearing debt and equity of $250.
Here are the balance sheets:
Here are the return-on-equity calculations:
Company B delivers a 55% ($137/$250) return on equity to its shareholder, versus 22% ($163/$750) for Company A – and the only difference between the two companies is the way they fund their assets (i.e., their capital structure).
How does this take place in the real world?
Case Study: Let’s assume Christa has $750 of investable cash, is buying the assets of Company A above for $750, and needs to decide how much debt and equity to use. She runs the numbers and chooses to borrow $500 of the $750 purchase price. Here’s her analysis.
First, she worries about putting all her equity in any single investment. If she borrows, she can leave some of her equity in other investments, thereby achieving a little diversification.
Second, she knows that by using debt she can lower her equity contribution in the business and increase her after-tax return on her equity.
Third, she makes a few assumptions for her analysis:
1. Investment horizon is 20 years.
2. The business is not growing.
3. Any equity not in the business is in a diversified portfolio of publicly traded stocks earning an after-tax rate of return of 8% ($10.5% pretax).
4. After-tax profit generated by the business is taken out at the end of each year and invested in public stocks.
5. If debt is used to finance the business, the desired level will be set and then maintained for all 20 years (through refinancing).
6. Ignore depreciation because it is a non-cash expense and will simply serve to reduce taxes and thereby provide a positive margin for error in the analysis.
Fourth, she runs numbers to estimate the value of her total $750 in equity in 20 years under various debt/equity mixes. Here are two of the mixes – No Debt ($0 debt/$750 equity) and Leverage ($500 debt/$250 equity).
The No Debt option begins with $750 invested in the business and $0 in public stocks. But each year, $163 is generated by the business and invested at 8% after tax. The Leverage option, in contrast, leaves $500 in public equities on Day 1 and $250 in the business. Annual cash generated under the leverage scenario is $137. The result?
Her total equity in Year 20, No Debt option: $8,188*
Her total equity in Year 20, Leverage option: $8,827*
* Sum of original equity placed in business plus equity in public stocks.
The Leverage option, under these assumptions, leaves her with more wealth in Year 20 and significant diversification (i.e., just 33% of her total equity in the business on Day 1; 66% in a diversified portfolio of public equities) in her investments.
Fifth, she calculates breakeven points for the various debt/equity mixes. She does this by adding up all the fixed costs of running the company, before costs of debt financing. She comes up with $450 – the total annual operating expense. Using the breakeven formula, she finds her breakeven level of sales under the No Debt scenario as follows:
Breakeven level of sales = fixed charges/gross profit margin
= $450/.4
= $1,125
Breakeven point under the No Debt scenario is annual sales of $1,125, a whopping 36% drop, and she still can make ends meet. The Leverage scenario ($500 debt/$250 equity) adds annual fixed obligations of $82, assuming the line of credit is interest-only and the term debt calls for repayment by equal payments of principal over a six-year amortization. As such, the annual fixed obligations are $532 per year and the breakeven level of sales is $1,330, calculated as follows:
Breakeven = $532/.4
= $1,330
So, under our leverage scenario, revenue can fall 24% without a crisis.
Sixth, she assesses solvency at varying profit levels and across various debt/equity mixes. The results are presented in the accompanying table.
As one can see, our investor has done her homework. She weighs her options, assesses her analysis, and chooses to borrow $500.
What is right for you and your business? There is no correct answer but rather a choice based on the investor’s goals, confidence and risk tolerance; and on the business’ predictability and profitability. But this writer believes that – as in the example above – one should give significant weight to the fact that borrowing enables meaningful diversification. Of course, if the debt requires the investor to pledge outside equities, then the value of the diversification would be significantly diminished.
What is the meaning of all this? As we said at the beginning, business owners should understand the impact of capital structure (mix of debt and equity used to capitalize the business) on their business and their wealth. The use of debt raises the rate of return enjoyed by equity holders – as long as the business is profitable and the return earned by the company exceeds the cost of the debt. In general, companies that enjoy steady cash flow have a greater ability to predictably meet fixed obligations and thus use incrementally higher levels of debt while keeping financial risk at manageable levels. Of course, the opposite is true for companies with more volatile operating cash flow.
For further introduction to these and related concepts, please read the accompanying articles. Methods for calculating optimal mix of debt and equity for a particular company call for considerable discussion. That is not the purpose of this article. The purpose is simply to introduce the concepts. A future issue of this publication may attempt to tackle this subject, but the business owner should seek the advice of a financial advisor skilled at private-company capital strategy.
Sensitivity Analysis
Gross Profit $550 $650 $750 $850
Operating Expense $450 $450 $450 $450
EBIT $100 $200 $300 $400
No Debt Leverage No Debt Leverage No Debt Leverage No Debt Leverage
Interest Expense $0 ($40) $0 ($40) $0 ($40) $0 ($40)
Taxable Profit $100 $60 $200 $160 $300 $260 $400 $360
Income Tax ($35) ($21) ($70) ($56) ($105) ($91) ($140) ($126)
Profit After Tax $65 $39 $130 $104 $195 $169 $260 $234
Principal Due $0 ($42) $0 ($42) $0 ($42) $0 ($42)
Cash Flow $65 ($3) $130 $62 $195 $127 $260 $192
ROA 9% 5% 18% 14% 26% 23% 35% 32%
ROE 7% 16% 13% 42% 20% 68% 26% 94%
Sidebar:
Remember, total assets always equal the sum of debt plus equity. This relationship is demonstrated by the following equation:
Assets = Debt + Equity
Of course, simple algebra can be used to manipulate the formula into equations that are also true, such as:
Equity = Assets – Debt
Sidebar:
Rate of Return Means Real Money!
Cash generated over 20 years from $100,000 returning 22% annually: $433,000
Cash generated over 20 years from $100,000 returning 55% annually: $1,092,000
Total Cash Generated by $100,000 Invested Over 20 Years
This article originally appeared in The Business Owner Journal, the periodical of choice for owners of small and midsize private businesses. All rights reserved, D.L. Perkins LLC. © 2012.
This publication is intended to provide general information on the subject matters covered. It is sold and distributed with the understanding that neither the publisher nor any distributor or advertiser is engaged in providing legal, tax, insurance, investment or other professional advice. The advice of a qualified professional should be sought before any reader applies a concept presented herein to his or her particular situation or business.
D.L. Perkins, LLC is solely responsible for this content.
