If you own a company, do you want the company to have a lot of debt or only a little? Of course, you’ll probably say you want as little company debt as possible, just like you’d want to have as little personal credit card debt as possible.
We’ve all been told since childhood that debt is bad and that it can make you poor. However, in (traditional) corporate finance, it is actually believed that more debt is “good”! Note that I say “traditional” because a more modern view by Modigliani and Miller says that it “doesn’t matter” whether a company has more debt or less debt. But it still doesn’t support your parents’ “no debt” advice!
How can more debt be good? First of all, let’s go back to an earlier concept of Rate of Return. If you invest $200 in a business and you get back $20 every year, what is your rate of return? 10% (Because $20 is 10% of your $200 investment).
What if, instead of investing the full $200 in the business, you invest $100 of your own money in the business and borrow the remaining other $100. And then, you still get back $20 after one year. How much is your rate of return now? Is it still 10%?
Nope, it’s now 20%! Why? Look… because you borrowed, you ended up investing only $100 of your own money this time (no longer the full $200), and then you got back $20. $20 is 20% of your own $100 investment.
So when comparing how much profit you get back compared to your own investment, you will find that you get back a much higher return when you borrow some or even all of the money needed for your business. The more you borrow (“more debt”), the higher your potential rate of return. The lower you borrow, the lower your potential rate of return.
Of course, having more debt also has risk. Risk of what? Risk of “insolvency,” in which your business’ debt is bigger than your business’ assets.
Let’s say you needed $200 worth of assets for your business ($80 worth of equipment and $120 worth of cash in the cash register). You invest your own $100 plus you borrow $100 from your friend… so you get your total of $200. And then let’s pretend that because of bad luck this month, your business loses $50. Therefore, the business’ new total assets become $150 (no longer the previous $200). Will your business still be alive? Yes. Your business has $150 in assets, but still only $100 in debt. It’s still “in the clear” by $50.
But what if you wanted to have lots of debt because it increases the potential rate of return? Let’s say you still needed $200 in assets. But this time, you invested only $40 of your own money, and then you borrowed the remaining $160… for a total of (still) $200 in assets. And then let’s say that suddenly, your business has bad luck this month and loses $50, just like in the earlier example above. How much are your company’s assets worth now? $200 originally, minus the $50 loss… you have $150 worth of assets (just like in the earlier example). However, how much is your debt; do you remember? It’s still $160. What does this mean? Your company has only $150 in assets, but it has $160 in debt! If your company were to pay back its debt today, it wouldn’t have enough assets to pay for the debt. This is called “insolvency” (more specifically, “balance sheet insolvency”). When a company has high debt, there’s a higher risk of insolvency.
Therefore, having high debt is a double-edged sword. It can increase the rate of return for the owners of a company, but it also increases the risk of insolvency. Note, however, that when you learn the propositions of Modigliani and Miller, you’ll see that increased debt may not actually increase a company’s rate of return. This is the essence of the very basic concept of Capital Structure and Debt Policy.