Friday, September 28, 2007/
“Neither a borrower nor a lender be!” So wrote Shakespeare, and he seemed to know a lot about management.
People frequently ask me for advice as to whether they should borrow money to grow their business and the answer is – “it depends!”
There isn’t any doubt that debt funding has been of enormous benefit to many companies in their pursuit of growth. Leading companies prefer debt funding for growth to a capital raising. The reason is simple.
If the money that is borrowed to grow the business is repaid and the revenue of the business increases, then the return on capital increases. However, if funding is achieved by a capital injection, then the capital base of the company is greater and even if the capital injection results in greater revenue, it has to be distributed to a wider capital base.
Suppose you have a company with capital of $1000 with revenue of $100, and you borrow $1000 to grow the business, which then achieves revenue of $200. Once you have paid back the loan, you have revenue of $200 on capital of $1000 (which is a 20% return on capital).
However, if you raise capital of say $1000 to achieve a revenue of $200, you don’t pay back the money and thus save a lot of interest (which in any event is tax deductible), but you then have to distribute the revenue to a capital base of $2000, which is 10% return on capital.
That, believe it or not, is the simple part. The more difficult part is the decision as to whether to raise money either by way of borrowings or capital. What we have to realise is that putting money into our company either by way of capital or borrowings is just as speculative as buying shares on the stock exchange, and so we have to have some measure or risk management to reduce our exposure to loss while enhancing our opportunities to successfully grow.
The basic test for borrowing money is the extent to which it will increase the value of the business. Too many struggling businesses borrow money to keep the doors open or pay the wages, with the result that they are simply generating income so that they can pay the bills. The purpose of generating income is to increase wealth. If, on a realistic assessment of the benefit of the borrowings, it is decided that revenue will grow, you can tick the first box.
The next box is whether the business can provide security for the borrowings. If you have to mortgage your home because there is insufficient security in the business to satisfy the lender, you should be very reluctant to tick this box because you are putting your basic asset on the line.
You should never do that unless you are convinced that the investment of your money in the business is secure. What you have to remember when you are borrowing money on personal assets and putting it into the business, you are becoming the lender to the business, not the bank.
The bank is lending to you and you are then using the money to put into the business. In other words, the bank is a secured lender and you are an unsecured lender. So, if the bank believes that the business is not a sufficient security and is passing the risk to you, it is worthwhile pausing for a moment and asking yourself whether you should be lending to the business if the bank is not prepared to do so.
The next box to tick, or not, is to examine the financial performance of the business and particularly the cash flow to determine whether the business in its current state can fund the borrowings. Too many people make projections on what they believe will be the financial case if they borrow the money and calculate that the ability to service the loan will follow from the borrowings.
That is really risky. If the business is not able to service the additional borrowings based on its current performance, then you are getting into really speculative territory by borrowing in the hope that the additional funds will generate the cash flow to service the debt.
I was once approached by a farmer who put to me his business plan to lease a property for 12 months and get the benefits of the crop. His calculations indicated a decent profit. His ability to service the rental (borrowings) would be determined by the success of the crop.
I asked him if he knew whether the next season would be a good one and if he knew what the price of grain would be when his crop came to the market. He said he didn’t, but was going on last season’s weather and price. I told him that the deal was too risky. He didn’t take my advice and the season was a disaster and he had to mortgage his own property to pay the rent.
Another guy came to me when the banks were selling Swiss francs. He said he could borrow money for three years at 3.5% and he was currently paying his own bank 10%. I asked him if he knew what the Swiss franc would be worth in three years and he said he didn’t. I told him not to borrow the money and he didn’t.
This is as simple an answer I can give to a complex question about which many books have been written.
To read more Louis Coutts blogs, click here.
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