For different businesses, there can strong be cases for basing growth on either debt or equity. Here’s the logic…
Debt or equity for growth?
In a perfect world (!), to grow your business you would use debt (loan funds supplied by others). The reason is simple: If you can use the debt to increase your profits more than the associated service costs of the loan, then the additional net profits increase your return on capital and thereby make your business more valuable.
Let’s check each step so you can clearly see the process.
We can see that we have taken on some new debt to acquire some new assets. The new assets must now generate sufficient additional profits to pay the increased expenses (including interest on the new debt), and cover the loan repayments before we are back in front again.
Start off in the above diagram with the new assets that we have acquired. Those assets are put to work to generate income and are used up in the process (become expenses). The new profits generated by the new trading will create extra cash for the business (once the debtors have paid, that is!). You can clearly see the cyclical nature of the fund flow from trading. Now what will we use the extra cash for?
Typically the extra cash would be used to repay the new debt (and possibly the existing debt too), acquire more assets for continued growth (above cycle in #2 repeats) and reward the owners with new dividends.
(Technical note: If you are wondering why there is an up arrow beside ‘new dividends’ (yellow side) when the other effect was a reduction in assets (green side), it is because the payment of the additional dividends will have the effect of reducing the retained earnings (accumulated profits) account in the equity section of the balance sheet. Green side and yellow side of the balance sheet both decrease and therefore remain in balance.)
Now if you had funded the above growth using an equity injection, say by taking on new equity partners, there would be no interest and principal payments for the new debt (partly offset by the loss of the tax deduction for the interest payments). So if everything else were equal, there would be a bit more extra cash generated using equity finance.
However, the shareholders, and particularly the new ones, will want their pound of flesh in the form of dividends (the payment of which are not tax deductible to the business). The dividends paid (existing and new) will now be across a broader capital base (more shareholders) so the return on capital will be less for each shareholder (like spreading slightly more jam across a much larger piece of toast).
You can imagine that it is possible to create complex mathematical models to work out the “ideal” mix of debt and equity. You can pay someone to do that if necessary.
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Remember though that beyond the numbers, you also need to carefully consider the pros and cons of taking on more debt compared to those associated with having more (demanding) equity participants and possibly a different composition to your board of directors.
Mark Robilliard and business partners Peter Frampton and Carmen Mettler started a journey to find a new way for anyone to ‘get accounting’ and use it in their job and life to create value. Accounting Comes Alive was born and now provides workshops all over the world using their unique and friendly Colour Accounting™ learning system that really does work, for everyone.
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