Is it bad for a company to have debt?
Leverage is defined as the set of payment obligations that a company has with banks, suppliers and various creditors.
Leverage has some advantages and disadvantages. Firstly, it is common for the entrepreneur to consider that leverage is a negative aspect for a company since there is no doubt that when a company is indebted and must meet its debts on a regular basis, it must generate enough cash to meet those payments. In other words, the risk of financial failure is added to the business risk. In addition, debt reduces the financial flexibility of the company and can lead to agency costs, understood as poor decision making due to the fact of being indebted or needing to take on debt to approach interesting business opportunities.
Agency costs arise from a conflict of interest between a company’s shareholders and bondholders, so that excessive leverage causes distortions in investment policies that can lead to a loss of value for the company. Example: investing in projects with low profitability or not providing capital for good projects.
On the other hand, it also has its advantages:
1.It is a cheaper source of financing than shareholders.
2. The interest on the debt is tax deductible, it is a tax shield.
3. Debt imposes discipline on managers (entrepreneurs or directors), i.e. when there is no money to spare, decisions are taken more cautiously, which avoids excessive optimism and a lack of caution in investment decisions or the assumption of spending commitments.
4. It is a positive symptom of the confidence that third parties outside the company have in its ability to generate money and meet its financial commitments.
5. If the company’s performance is positive, debt increases shareholder profitability as the latter has more funds available for the development of the business in relation to the equity invested.
Therefore, financial leverage can become a competitive advantage as a leverage factor to boost business growth, if the cost of debt is lower than the weighted average cost of capital, it is a technical issue, not an emotional one.
Alberto Arranz, CEO of Delicias Capital, gives us his views about Corporate Leverage
Normally, business leverage is not a bad thing. However, as our Spanish illustrious writer, Francisco de Quevedo Villegas would say: “the greatest evil is not to owe, but to be afraid of not paying“.
Therefore, lending to a company that during a moment of adversity, would have no qualms about failing to meet its financial commitments, is certainly not the most advisable thing to do from the perspective of the investor or lender.
Thus, an analysis to know what the debt is being borrowed for, would be required:
- If it is to finance or cover losses carried forward from previous years.
- If it is to finance cash and value-generating investments.
In the first case, the probability of default is much higher than in the second case.
In either case, the key is the balance between cash generation capacity and debt service, understood as the payment of debt and interest.
If lenders are willing to lend us their money, it is because they trust in the company’s performance.
And how can money be generated to meet financial commitments?
There are several ways:
- The most positive and logical one, through the company’s own activity, i.e.income minus expenses, which means, collections minus operating payments.
- The application of efficient collection and payment policies. That is, the improvement of its operating cash requirements.
- The sale of productive or non-productive assets of the company. For example, through a lease-back.
- The increase of debt, i.e.replacement debt.
- The contribution of its partners.
In conclusion, the important thing is to know whether the debt can be repaid, whether there is the capacity to repay and the purpose of the debt, i.e. how it is to be used.