Articles Search Engine

There is now general agreement that economics and finance were equally culpable in getting us to where we are now; the global slump. If packaging toxic receivables in to asset-backed securities was a finance ’cause’ then several countries herding in to invest in them was the economic ‘effect’. Both suffered in the process: several global brand names in business disappeared overnight whilst the richest of the nations found themselves debt-trapped.

The fixation with ’shareholder value added’ drove businesses to innovate: so much so that finance ’strategy’ was forced to give way to financial ‘engineering’. As quantitative analysts (quants) reduced businesses to mathematical models, fundamental principles in finance, for example rules in gearing, were conveniently overlooked. And that wrote the obituary of several businesses, large and small ones alike. With availability of finance drying up for businesses parallels of debt financing are being drawn with ‘horror’ stories!

So, is debt financing really a dangerous option?

Trading conditions

For a highly geared company the trouble starts when trading conditions worsen. As sales drop pressure mounts on cash. Forget about the benign effect of tax savings from interest pay-outs, the focus now is on the cash needed to service and retiring the debt. The interest burden begins to eat in to margins and there is absolute scramble for cash; the first sign of collapse.

After nearly a century of ‘cost leadership’ the UK retailer Woolworths seems to have gone down this route. During the last five years to its eventual collapse in 2008 its revenue remained stagnant at about GBP 2.70 billion while operating profit thinned considerably and was just about one percent of the revenue just before its demise! Contrast this with its current liabilities that nearly doubled over the same period!

Rule No 1: When trading suffers shift your focus towards retiring debts and re-negotiate with your lenders.

Structural flaws

Debt being a cheaper option relative to equity there is always that temptation to go for debt-shopping, hardly realising that mounting debts is like a time bomb; could go off anytime! Unlike shareholders the lenders could always walk out if there is trouble brewing. One way to be prepared for a situation like this is to use debts to buy assets that perform. Borrowing to pay off salaries and expenses can really be a bad idea! Because, should trouble set in, disposal proceeds of the assets could take care of the debts. That said, what should be an ideal debt level depends on which industry you are in or at what stage of growth your business is in, brick and mortar companies generally consider debts of 2 times the equity manageable, though.

Rule No 2: Always match debts with assets that add value

Debt servicing

Another key determinant in debt financing is your profit margin. Ideally you should be generating sufficient money after paying off all the operating expenses to not only pay interests, taxes and your investors but also to fund your growth. This is the why businesses operating on thin margins are a risky proposition to potential lenders. The Woolworth case is a classic one. Nearly three quarters of their operating profits were consumed by interest payments, leaving the shareholders high and dry and growth totally dependent on more debts!

Rule No 3: Those operating on thin margins; think twice before committing to high interest loans!

Cash flow mismatch

Timing of your cash flows is yet another factor that could limit your borrowing capacity. As a good start your operations should be cash positive; your sales can’t be locked up in unduly long receivables. Nor you can use a 1-year debt to build a manufacturing facility that will generate cash from year 3 on. Your cash inflows and outflows need to match in terms of quantity and time. To illustrate, to pay off your GBP 5 million debt in year 3 you have to have cash inflow maturing for GBP 5 million in year 3 itself.

Rule No. 4: Always match your asset profiles with those of your liabilities

To conclude, debt financing is like steroids; an overdose kills the body itself!