INSIGHTS

In this jargon buster we explain why companies use debt and some of the benefits of using debt over equity.

Why do companies have debt in the first place?

As consumers we normally take on debt to buy things that we don’t have enough money for, be it a house, or a car. We are willing to pay interest on the borrowed money so that we can have those things now, even though it costs us more in the long run. But why would a company that most likely could raise the additional funds from investors if it wanted to, choose to have debt? The answer is that debt is usually cheaper than equity.

Debt and equity are the two main ways a company can finance its activities. Debt is the money provided from banks or bondholders, while equity is the money that shareholders have contributed.

Why is debt usually cheaper?

When a company issues debt, it is required to pay the holders of that debt a certain amount of interest every year over a set period of time (say ten years) at which time the principal is repaid. However, when a company issues equity, it is giving away a percentage of future profits into perpetuity. Another factor is that, should the business fail, debtholders are paid before shareholders. Shareholders are last and take on more risk as a result. Consequently, they demand a higher rate of return.

Debt acts as a lever

The amount of debt a company has in relation to its equity is called its leverage, also known as gearing. This is because debt acts somewhat like a lever (or a gear) in that taking on more debt can boost shareholders’ returns – just like a longer lever is capable of moving a greater weight.

Let’s look at an example with two companies, Conservative Co and Aggressive Co, to see how this works. Both companies have the same amount invested in the business ($10,000), earn the same amount of revenue ($5,000) and have expenses of $3,000 leaving a profit (before interest) of $2,000. However, Conservative Co has no debt, so $10,000 in equity, while Aggressive Co has $5,000 of debt and $5,000 of equity – thus it has gearing of 50%.

Assuming an interest rate of 5% on the $5,000 of debt that it holds, Aggressive Co has an extra interest expense that Conservative Co doesn’t have. Conservative Co therefore has a higher net profit - $2,000, as compared to Aggressive Co’s $1,750.

So, if Conservative Co has earned more profit than Aggressive Co, how can debt be beneficial? To answer that question, we must look at the return shareholders are earning. Shareholders of Conservative Co have contributed $10,000 of capital, whereas those of Aggressive Co have contributed just $5,000, opting to fund the remaining $5,000 with debt. This means that shareholders in Conservative Co have made a return of 20% on their money – not a bad return. However, shareholders in Aggressive Co have made a return of 35% on their money.

Another way to see leverage at work is to think about a mortgage. Let’s say you buy a house worth $500,000 with a 20% deposit – so $100,000. If the price of the house increases to $600,000, the value of your equity in the house goes from $100,000 to $200,000 - as the amount of debt is fixed. The gearing effect has turned a 20% price rise into a doubling in equity. Conversely, if the price of the house falls to $400,000, the value of the equity goes from $100,000, to $0.

How much is too much?

The beneficial effects of gearing work up until a point. After that, too much debt becomes a major risk. Should profits fall unexpectedly, the company risks not being able to meet its interest payments and going bankrupt.

So, how much debt is too much debt? This really depends on how reliable and steady a company’s profits (and more importantly its cash flow) is. A company that is able to forecast its future earnings with a high degree of certainty can take on more debt. However, those with more volatile earnings are able to take on less debt. It is for this reason that companies like Port of Tauranga or Vector are able to have much higher leverage than the likes of Air New Zealand or Kathmandu.