What it means
Every business is funded by some mix of borrowed capital and equity, and the balance between them is called the capital structure. Borrowed capital is cheaper than equity because lenders take less risk and are paid first, but it carries a legal obligation that equity does not.
Interest is normally deductible against tax, which reduces the real cost of borrowing. A loan at 8% interest for a company paying 25% tax effectively costs 6% after the tax relief, which is why debt often looks attractive next to the return shareholders expect.
The value of borrowed capital comes from the gap between what it costs and what it earns. If money borrowed at 8% is invested in operations returning 14%, the surplus belongs entirely to the existing shareholders, since the lender's share was fixed at 8%.
That effect works in reverse just as powerfully. This is financial leverage: the same borrowing that multiplies returns in a good year multiplies losses in a bad one, because interest must be paid whether or not the investment performed.
Lenders manage their own risk through covenants, security and repayment schedules. A charge over property, a limit on total debt relative to profit and a requirement to maintain interest cover are all normal, and breaching them can make the whole balance repayable on demand.
In practice
Real-world examples.
Example
A haulage firm finances twelve trucks on five year leases rather than buying them outright. The monthly payments are borrowed capital in substance, and the trucks generate more contribution than the finance costs.
Example
A family owned brewery takes a $2,000,000 loan secured on its site instead of selling a stake to an investor. The family retains full ownership and repays the loan from cash flow over eight years.
Example
A retailer funds seasonal stock with a $600,000 revolving facility drawn in August and repaid in January. The facility is borrowed capital used purely for working capital rather than for long term assets.
Formula
Calculation
After-tax cost of debt = interest rate x (1 - tax rate)
Debt to equity ratio = total borrowed capital / shareholders' equity
A distribution company borrows $500,000 at 8% to fit out a new depot. Annual interest is $500,000 x 8% = $40,000, and with a 25% tax rate the after-tax cost is 8% x (1 - 0.25) = 6%, or $30,000 a year in real terms.
The depot is expected to generate an operating return of 14% on the money invested, which is $500,000 x 14% = $70,000 a year. The surplus over the interest cost is $70,000 - $40,000 = $30,000 a year, and that surplus accrues to the shareholders without any of them putting in a further penny.
The company has $1,000,000 of shareholders' equity, so the debt to equity ratio becomes $500,000 / $1,000,000 = 0.5. If the depot instead returns only 5%, or $25,000, the business is $15,000 a year worse off and still owes the full $40,000 of interest.Case study
Seen in the real world.
The following is a fictional, illustrative scenario. Ashcombe Packaging, an invented maker of protective cartons, had $1,000,000 of shareholders' equity and no debt when it decided to add a second production line. The line cost $500,000, and management borrowed the full amount over seven years at 8%, generating a $40,000 annual interest charge.
In the first two years the line performed as planned, adding around $70,000 a year of operating profit against $40,000 of interest, so shareholders gained roughly $30,000 a year for no additional investment. The fictional board, encouraged, borrowed a further $900,000 for a third line and a warehouse, taking debt to $1,400,000 against unchanged equity and lifting the debt to equity ratio to 1.4.
Then Ashcombe's largest customer moved production overseas, taking 30% of revenue with it. Operating profit fell below the $112,000 annual interest bill, the interest cover covenant was breached, and the bank required a repayment plan that consumed almost all free cash for three years. The first borrowing had been sound and the second was simply too much of the same thing, which is usually how leverage causes trouble.
Watch out
Common mistakes.
- Judging borrowing only by the interest rate rather than by whether the money will earn more than it costs.
- Funding long term assets with short term facilities such as overdrafts, which can be withdrawn exactly when the business is under pressure.
- Focusing on the monthly repayment while ignoring covenants, security and personal guarantees attached to the facility.
Questions
People also ask.
Is borrowed capital cheaper than equity?
Usually yes, because lenders rank ahead of shareholders and accept a lower return, and interest is normally tax deductible while dividends are not.
How much debt is too much?
It depends on how stable the cash flow is, but interest cover falling below roughly three times operating profit, or debt above three times annual profit, is where most lenders start to worry.
Does borrowed capital dilute the owners?
No, that is its main attraction: lenders take no ownership, so all the upside beyond the interest cost stays with existing shareholders.
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