Debt is Good or Bad for Company?

How to know if more debt is good or bad for company?

On a personal front, an individual must always try to live a debt free life.

But debt for a company, may not be bad.

Sure, debt is not apt for all companies. But for some, debt acts like a leverage.

For such companies, debt helps to increase their EPS.

All good companies always tries to improve their EPS over time. Why?

Because it ultimately leads to higher shareholders returns.

Higher EPS leads to the following:

  • Share’s market price goes up.
  • Dividend per share may also go up.

If debt can help a company improve their EPS, nothing like it.

But the caution is, debt is not suitable for all companies.

How to know if debt is good or bad for a company or not?

This article will elaborate just that.

#1. Investors must always be touchy about debt

For companies, availing debt is normal.

Unlike individuals, companies, do not take debt for overspending.

But this is also a fact that, not all companies has appetite to digest debt.

In financial terms, “appetite for debt” is called “financial leverage”.

A company which has high financial leverage can use debt to improve its EPS.

Hence investors must always check the “financial leverage” of the company before investing.

Idea is to know, if the company is utilising debt profitably or not.

#2. Companies cannot take any amount of debt

Even if the company’s “financial leverage” is high today, it does not mean that it can take any amount of debt.

To understand this concept, lets ask a basic question.

Why companies take debt?

Debt is a “source of fund” for the companies.

A typical company can have the following source of funds:

  1. Equity
    • Common stocks.
    • Preferred stocks.
    • Accumulated reserves
  2. Debt
    • Long term debt.
    • Short term debt.

Why companies need funds?

They need funds to finance their operations.

This money is used to pay for the raw materials, utility bills, salaries, etc.

“Funds” are like blood flowing in the veins of the company.

It is easier to raise funds by debt. Hence companies often fall in the trap of “excess debt”.

Investors must always stay away from such companies.

How much debt can be tagged as “excess”?

To answer this question, lets understand a theory first…

#2.1 Capital Structure of a company

Companies use “equity and debt” an their “source of funds”.

Capital structure means, what proportion of debt and equity is used by the company to finance its operations.

Capital Structure = Debt / Equity

For every company, a typical proportion of debt/equity ratio is profitable.

There is no thumb-rule which says, a particular capital structure will work for all companies.

In fact, it is the “inherent business attribute” of a company which decides its optimum capital structure.

What is optimum capital structure?

Right proportion of debt and equity financing.

All good companies uses the concept of “Financial Leverage” to set up their optimum capital structure.

Idea is to have a right mix of debt and equity, which ultimately results in enhancement of EPS.

#2.2 What is the concept of financial leverage?

Suppose there is real estate property worth $100,000.

Ram uses his own funds ($100,000) to buy this property.

In this case we can say that Ram is not using any financial leverage to buy the property.

On the other hand, Raj uses his own funds ($20,000) & debt ($80,000) to buy this property.

Here, Raj is using financial leverage to buy the property.

To understand the utility and limitation of financial leverage, lets see few cases…

Case 1 – Value of property goes up by 10% ($10,000) after 1 year.

Ram:

  • Sale value: $110,000.
  • Cost: $100,000.
  • Profit: $10,000.
  • ROI: 10%

Raj:

  • Sale value: $110,000.
  • Debt repaid: $87,000 (with interest @8.5% p.a.).
  • Balance: $23,000
  • Cost: $20,000
  • Profit: $3,000
  • ROI: 15% (3000/20000)

As financial leverage was used by Raj, his profitability (ROI) is better than Ram.

Caution: Financial leverage will work in your benefit only if the property value is increasing at a rate close to the interest paid on the borrowed money.

Case 2 – Value of property goes up by 5% ($5,000) after 1 year.

Ram:

  • Sale value: $105,000.
  • Cost: $100,000.
  • Profit: $5,000.
  • ROI: 5%

Raj:

  • Sale value: $105,000.
  • Debt repaid: $87,000 (with interest @8.5% p.a.).
  • Balance: $18,000
  • Cost: $20,000
  • Profit: -$2,000 (loss)
  • ROI: negative (-10%).

Note: Raj made a loss as property value appreciated by only 5%. Interest paid on debt was 8.5%.

Case 3 – Value of property goes up by 7% ($7,000) after 1 year.

Ram:

  • Sale value: $105,000.
  • Cost: $100,000.
  • Profit: $7,000.
  • ROI: 7%

Raj:

  • Sale value: $107,000.
  • Debt repaid: $87,000 (with interest @8.5% p.a.).
  • Balance: $20,000
  • Cost: $20,000
  • Profit: Zero
  • ROI: 0%

Note: Raj made no-profit no-loss as the property value appreciated by only 7%. Interest paid on debt was 8.7%.

Companies use the same concept of financial leverage to decide their capital structure.

Till the ROI (Return on Investment) is greater than the “cost of debt”, debt financing will remain profitable.

What it means by profitable?

Means, every addition of debt in capital structure will enhance the EPS (Earning Per Share).

#3. How debt affects EPS?

What is EPS?

EPS = Net profit (PAT) / number of shares outstanding.

Case 1: Company has no debt (Leverage = 0)

Capital Structure:

  • Equity: $50,000
  • Number of share: 5,000 shares @ $10 each.
  • Debt : NIL
  • Total Funds Available: $50,000
  • Tax Rate: 30%
  • PBIT: $4,500 (9% of Total Funds)
  • Interest on debt: 10%.

Lets calculate the EPS:

PBIT$4,500
– Interest @ 10% on debt(NIL)
PBT$4,500
– Tax @ 30% on PBT($1,350)
PAT$3,150
EPS = PAT / No. of Shares$0.63 (3150/5000)

Case 2: Company takes some debt (Leverage = 20%, PBIT-9%, Interest-10%)

Capital Structure:

  • Equity: $50,000
  • Number of share: 5,000 shares @ $10 each.
  • Debt : $10,000
  • Total Funds Available: $60,000
  • Tax Rate: 30%
  • PBIT: $5,400 (9% of Total Funds)
  • Interest on debt: 10%.

Lets calculate the EPS:

PBIT$5,400
– Interest @ 10% on debt($1,000)
PBT$4,400
– Tax @ 30% on PBT($1,320)
PAT$3,080
EPS = PAT / No. of Shares$0.62 (3080/5000)

Note: Due to debt, EPS decreased from $0.63 to $0.62. This debt financing has proved detrimental to the shareholders.

Case 3: Company takes some debt (Leverage = 20%, PBIT-9%, Interest-8%)

Capital Structure:

  • Equity: $50,000
  • Number of share: 5,000 shares @ $10 each.
  • Debt : $10,000
  • Total Funds Available: $60,000
  • Tax Rate: 30%
  • PBIT: $5,400 (9% of Total Funds)
  • Interest on debt: 8%.

Lets calculate the EPS:

PBIT$5,400
– Interest @ 8% on debt($800)
PBT$4,600
– Tax @ 30% on PBT($1,380)
PAT$3,220
EPS = PAT / No. of Shares$0.644 (3220/5000)

Note: Due to cheaper debt, EPS increased from $0.63 to $0.644. This debt financing has proved beneficial for the shareholders.

Conclusion:

Following abilities of a company decides if debt is good or bad for the company:

  • Ability to generate higher ROI.
  • Ability to source cheaper debts.

When interest on debt is less than ROI, debt will prove beneficial for the shareholders. How?

Because is this case, every unit of debt added will increase the company’s EPS.

This means capital appreciation for shareholders.

For an average business, the only ways to improve the EPS is by increasing the sales or profitability.

For a company with higher ROI (more than cost of debt), they can improve EPS by simply taking more debt.

Such companies are said to “enjoy the benefit of financial leverage”.

Such companies may or may not improve their sales or profitability to increase EPS.

It is a huge advantage for any company.

Needless to say that, there are not many companies around which can boast of such a benefit.

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