Has your business considered leverage?
Gearing or leverage in the financial world refers to funding a portion of the capital in your business using debt. Large corporates usually understand the benefits of leveraging their capital structure with an optimal level of debt which is known to be cheaper than equity as returns expected by equity holders are normally greater than the prevailing interest rates. However, many privately held businesses consider debt to be the funding of last resort instead of being an integral part of their capital structure strategy.
The chart below illustrates how a private company can decrease its weighted average cost of capital (WACC) and increase return for equity investors by including debt in the capital structure.
The analysis above assumes:
- Cost of equity of 20% based on returns expected by investors in mid-sized private businesses in Australia;
- Return on assets of 20% in line with cost of equity;
- Cost of debt of 6.0% based on a premium of ~2.5% over yields on BBB rated corporate bonds in Australia;
- Tax rate of 30%; and
- Debt at 0% to 35% of the total value of business.
WACC in the above analysis goes down from 20% to about 15% by including debt in the capital structure. Leverage also helps increase the returns for the equity holder as suggested by a higher implied return for the equity holder with greater leverage.
An important thing to note here is that leverage magnifies the risk to equity holders when a business is loss making as the interest is an
additional obligation. Sustained losses with high levels of debt can increase solvency risk. As such, it is important to assess the optimal level of debt for the business based on its capacity to service debt under different scenarios.
Beyond the numbers
Mathematics aside, there are other reasons to consider including debt in the capital structure. This is especially true for business owners that may be looking to exit in the near future. Here is a list of things that a business may be “forced” to do as it takes on external debt:
- Strengthen accounting processes;
- Streamline budgeting and forecasting process;
- Monitor covenants and review business performance frequently;
- Manage cashflows with more discipline; and
- Report to external stakeholders including banks or other lenders.
While some of these may seem to be an unnecessary compliance burden, these are traits that make a business attractive to potential investors. As such, the process helps prepare a business for external investors and their due diligence when they come calling.
A substantial portion of risk for privately held businesses comes from unreliable historical reporting and absence of checks and balances.
Taking on external debt forces businesses to focus a lot more on these issues than they usually would.
Even if an exit is not on the cards, creating a debt strategy can help businesses to:
- Free up a portion of invested capital and increase ability to pay dividends;
- Free up seasonal working capital locked in the business; and
- Provide access to immediate funding to ride through unforeseen cashflow events such as delay in payments from major customers.
The right structure
There are a range of funding alternatives available for companies looking to raise debt. The available alternatives typically differ based on security, charge on assets, features and source of funds as noted in the table below.
The nature of business and its funding requirements typically determine the appropriate debt funding structure.
Happy to help
We have helped many businesses in creating an optimal capital structure and securing debt funding from banks, non-bank financial institutions and private investors. Our team can provide an end-to-end debt advisory service to secure funding or help in specific areas such as building financial forecast models and business plans.
Feel free to contact your trusted advisers at PKF for a discussion on your capital structure strategy and funding needs.