By Rangsan Thammaneewong
Over several years of working in the financial industry and as a management consultant, I have often been asked by borrowers and clients the question of the right level of ‘debt to equity’ for their companies or new projects. Many were looking for the ‘right’ ratio or hard and fast rules for deciding the figures. My answers were hardly the same every time which often made my assistants, who had been following me to different clients, raise their eyebrows. My answers ranged from close to minimal borrowing to higher than three to one. I was often reluctant to pick a number because it depended on various factors. But with sufficient guidelines, the clients usually came to a number that was comfortable to them and usually close to what I had in mind. Here are some of the factors I use that will help decide what the appropriate ratio should be for you or your company.
1. Probability of Cash Flow
If you have an uncertain cash flow, you should limit the amount of debt you take on. Debt servicing can prove to be a huge burden to any business. At best, it is a series of monthly obligations that need to be recorded and made. At worst, it can drain enough cash out of a business to disrupt operations and doom the business. Debt servicing is only one of a few expenses that must be met every month. Others include overhead costs and payroll. Therefore, cash flow is very important. Certainty of cash flow depends on several factors, e.g. particular nature of the products, the nature of the business, economic conditions, industry competition, state regulation, etc.
The demand elasticity of your product will have an effect on your cash flow. Products that are necessities guarantee a more steady cash flow since their price elasticity’s are low. On the other hand, luxury items usually have high price elasticity’s, and in the event of price increases, the demand for these products drops significantly, drastically lowering cash flow. For example, when the economy is bad, many people would choose to dine at home or in cheaper places rather than expensive meals in fancy restaurants.
The nature of the business is very important as well. Is it a business where cash is needed for everyday transactions, like a convenience store? Or is it a business where most of the transactions are done on a credit basis? What are the credit terms being extended to customers or what are the credit terms the company receives from its vendors? Are we collecting receivables promptly? If not, this will eat into our cash flow. What kind of products do we sell? If we’re in an industry where product lines change quickly, we want to borrow less to finance our inventories like computers and IT, since our inventory will deteriorate in value while our debt increases over time with interest.
Market positioning and industry competition are also contributing factors. Who are our competitors? How can they affect our sales? Do we have any advantage that will allow us to keep our position in the market? For example if you have a concession to sell electricity or water to the public, even in a recession, you would not encounter tightened liquidity from declining sale revenues as compared to real estate developers. No matter what people need electricity and water to live, while they don’t have to buy new homes when times are tough. In addition, due to the concession, you can sell water at a much more competitive price than newcomers, creating a natural barrier to market entry by new competitors.
Government regulations, such as tax and regulatory laws, can come into play as well. For example, if you are in a business with highly regulated price controls, increased costs will affect your cash flow and thus your debt financing level. Or if you are in a business that requires licenses from authorities and new licenses will no longer be issued, you could comfortably increase your leverage ratio.
2. Level of Interest Rate & Term of Debt
The higher the interest rates are, the less attractive borrowing becomes. Interest is simply the price of money. Lower interest rates encourage us to borrow more and spend more. When interest rates are high, we may want to finance ventures through equity, and not debt. High interest expenses create troublesome debt servicing obligations.
Another factor is the term of debt. If we manage to get low interest rates and extended principal repayment schedules, then borrowing money would become cheaper. Outstanding debt principal is not as much of an issue as debt servicing obligations. What usually crushes a business is its inability to service the regular interest expenses.
3. Issue of Personal Guarantee
Statistics from the USA quoted by Michael Gerber in his book “The E-Myth” quoted as follows:
- 50% of businesses failed within their first year of inception
- 80% of businesses fail in the first five years. Of the 20% that survive, 80% of those fail in the second five years.
That means a grand total of 96% of new businesses fail within the first ten years. That is one out of every 25 ventures that will be successful after ten years. From my experience in the past couple decades, I have seen countless businesses come and go, many of these companies were the leaders of their industry at times.
Given this, what sort of personal guarantees are you willing to provide to potential investors, and more importantly, for bank loans and such? Are you willing to provide personal collateral to secure a loan, such as the deed to your house?
Another factor here is the structure of your business. Some businesses have limited liabilities, such as corporations, LLPs and etc. Under these establishments, your exposure is limited to your investment in the firm. Others, such as sole proprietorships, have unlimited liabilities, and you may be trapped with far more obligations should the business fail, and the debt that you take on will be added onto all that.
4. Your Risk Aversion Level
Different people have different affinity for risks. Individual risk preference factors into what sort of businesses we decide to enter. In addition, the risk preference of business owners also plays a role in their decision making on funding sources and target capital structure. We see stories of several businessmen who committed suicide during the financial crisis or even before the crisis unfolded; we also may have seen several businessmen who had insurmountable debt during the crisis and may or may not have managed themselves out of these debts but still lead normal lives today.
This is a broad overview of what financial decision-makers may have to deal with, or should deal with, before applying for a loan. Depending on the nature and state of the company and the urgency of the loan, some of these factors become more crucial than others, and that is where professional advice may be helpful to help identify priorities based on urgency and importance of the current situation and the future of the company going forward. Whether you are a healthy business looking to expand or a struggling business trying to rebuild, the road to your goal may not be easy. Rome wasn’t built in a day. Neither was your company. Never compromise your goals for a quick financing close. Sometimes “It’s not how fast you’re going, but it’s where you’re going to”.