People refer to debt as leverage, because at a certain level of earnings, debt will increase the return on equity (ROE). The reason: There are only two ways to capitalize a business, debt and equity.
Related: How to Make Debt Work For You
Let’s say that a business needs $1 million of capital to get going and that the capital is raised entirely from equity. That is, investors put up $1 million in exchange for an ownership interest in the company. Therefore, the equity in the company is $1 million. If the company makes $100,000 in the first year, the investors will get $100,000 for their $1 million investment. The investor’s ROE will be 10 percent ($100,000 of profit per $1 million of equity).
On the other hand, suppose the company capitalizes itself with $500,000 of equity and $500,000 of debt. The company still has the same $1 million of capital. However, if in the first year, the company earns the same $100,000 of profit, the ROE is now 20 percent ($100,000 of profit / $500,000 of equity). Therefore, debt leverages the ROE. If the total capitalization stays the same (in this case, $1 million), for a given amount of profit (in this case $100,000), the more debt the company has, the less equity it needs and the higher its ROE will be.
However, more debt isn’t all good news. Debt requires repayment with interest. In general, if the debt isn’t repaid in a timely manner, the debt-holders can force the company into bankruptcy. That is, they can force the company to liquidate its assets to repay the debt (or, at least, as much of the debt as the company has assets to cover).
Companies without debt don’t face this risk. There are no required payments, no threat of bankruptcy if the payments aren’t made. Therefore, debt increases the company’s risk.
Some people say that all companies should have some debt. Let’s explore. We could launch into a very theoretical discussion about maximizing something called the risk adjusted rate of return. However, rather than doing that, let’s simply say that some debt may be a good thing if:
- It means that equity investors have to put less money into the business (or leave less money in the business). Therefore, the equity investors have more capital they can invest in other things.
- The equity investors can find other ways to invest their capital that will yield a return that is greater than the cost of the debt.
- The increased risk to the business is manageable and doesn’t more than offset the increased ROE.
The above guidelines, while helpful, certainly don’t allow the precise calculation of how much debt is appropriate. While we could give you a series of formulas that would allow the calculation of an optimal amount of debt, that exercise would involve estimates and assumptions that would render the result imprecise at best. We think it is better when companies return capital to shareholders by taking on debt (or allowing shareholders to keep their capital), as long as the company can cover its debt payments, even in the event of a significant downturn in business.
How much debt to take on is not an exact science and requires sound judgment, but that is the nature of business. No matter how much math you do, good judgment is always required.