Debt Financing

A business that needs money for growth, for assets, for an acquisition or simply to fund its working capital has two sources beyond its own profits: it can sell a share of itself, or it can borrow. Borrowing keeps ownership intact, which matters to founders and to shareholders who do not want to be diluted, and it is usually cheaper, because lenders take less risk than shareholders and accept a lower return, and because the interest they receive is deductible against the borrower's taxable profits.

A company paying 7% interest with a 25% tax rate has an after-tax cost of debt of 5.25%, well below the return equity investors expect. The catch is that the cost is fixed.

Interest and repayments fall due whether or not the business is doing well, and a business that cannot meet them faces default, enforcement of security and possibly insolvency. Debt comes in many forms, suited to different needs.

Term loans from banks provide a lump sum repaid over a period, usually secured on assets and subject to covenants. Revolving credit facilities and overdrafts fund working capital, drawn and repaid as needed.

Bonds and debentures raise larger sums from investors for longer terms, often at fixed rates. Asset-based lending borrows against specific assets: receivables through invoice finance, inventory, equipment through hire purchase or leasing, property through mortgages.

Mezzanine debt sits between senior debt and equity, unsecured or subordinated, with a higher rate and often an equity kicker. Convertible debt starts as a loan and may become shares.

Matching the form of the debt to the asset being financed and the cash flows that will repay it is basic discipline: long-lived assets should be financed with long-term debt, and short-term needs with short-term facilities. The right amount of debt is the subject of a large literature and a simple intuition.

Up to a point, debt improves returns to shareholders, because the business earns more on the borrowed money than it pays for it, and the tax shield on interest adds value. Beyond that point the risk of financial distress rises faster than the benefit: covenants tighten, lenders charge more, suppliers and customers grow nervous, management attention shifts from the business to the balance sheet, and a downturn that a lightly borrowed company would survive becomes fatal.

Where the point lies depends on the stability of the business's cash flows. A regulated utility with predictable revenues can carry debt at several times its earnings; a cyclical or early-stage company should carry little or none.

Lenders assess a borrower on capacity, security and covenants. Capacity is the ability of the business's cash flow to service the debt, measured by ratios such as debt to earnings before interest, tax, depreciation and amortisation, interest cover and debt service coverage.

Security is what the lender can take if the borrower fails: fixed and floating charges, guarantees, specific assets. Covenants are the promises the borrower makes to maintain financial ratios, limit further borrowing and dividends, and report regularly, which give the lender early warning and the right to intervene.

The borrower's task is to negotiate terms it can live with in a bad year, not just a good one, and to keep headroom under the covenants. The decision between debt and equity for a particular need is made by comparing the effect on returns, risk and control.

Debt raises earnings per share when the return on the project exceeds the after-tax cost of borrowing, and it preserves ownership; equity lowers earnings per share in the short term and dilutes owners, but it carries no obligation and strengthens the balance sheet for the next downturn or the next opportunity. A common analysis calculates the level of operating profit at which the two options give the same earnings per share; above it debt is better, below it equity is safer, and the question becomes how likely profit is to fall below that level.