Financial Times

Pros and cons of borrowing against raising equity

You do not have to look far to find cautionary tales about borrowing. In recent years, the banking and finance sectors have provided some outstanding examples of how high levels of debt exposure can cause even large and apparently robust financial institutions, like Long Term Capital Management (LTCM), or even national industries (such as Japan's banking sector) to lose their footings. These large-scale corporate horror stories can have unfortunate and long lasting effects as the resulting lack of liquidity and tightening up inevitably filters down to smaller clearing banks and their customers.

The origins of LTCM's financial woes can be traced back to Russia's 1998 default on billions of dollars of debt. Some of the world's biggest banks lost hundreds of millions, which they had invested in Russian assets. Not only were those assets impossible to sell once the Russian Government had defaulted on its loans, but many institutions had funded the investment on borrowing.

In LTCM's case, its borrowings - even those in safe bets like US government bonds - proved impossible to turn into cash. Ultimately, LTCM had to be bailed out by the US Federal Reserve, which was concerned about the knock-on effect on other institutions. At around the same time, Japan's banking sector faltered as confidence in the newly industrialised countries collapsed. The crisis in emerging and high risk economies, like Thailand and Indonesia, left Japanese bankers over-exposed and government intervention became inevitable. Today, experts believe that Japan's banking industry is still distorted and that smaller companies operating in that market will suffer higher costs of capital for some time to come.

Borrowing - pros

For small or growing companies, borrowing is not only the most obvious source of capital but, in the right conditions, it can be the most viable. The main alternative - selling equity - can prove unrealistic by comparison. The first consideration is one of value. The main attraction that borrowing has over equity is that a straightforward bank loan protects the owner-manager from having to sign over too much in the way of future profits.

Start-ups especially do not have much value initially and entrepreneurs can often find themselves with little or no leverage in negotiations and may end up surrendering far more equity than they would like. The outside investor is looking to acquire shares which will grow in value. If all goes well and the shares do increase in value, the owner-manager will have diluted his store of potential gains. A straightforward loan lasting a few years has the virtue of being finite and easier to manage. Provided interest payments are maintained, control remains with the owner-manager. There is an additional benefit to bank loans. In most industrialized countries interest payments attract tax relief, making debt a cheap way for companies to finance themselves. And, with corporation tax rates ranging from 30% to 60%, this benefit alone makes borrowing a persuasive option.

Even without the tax relief, debt is cheaper than equity. Creditors are ahead of shareholders in the line for pay-outs should a company fail. They are therefore prepared to accept a lower rate of return in exchange for this lower level of risk.

Borrowing - cons

Gearing up undoubtedly has advantages as a means of raising finance, mainly in terms of cost of capital and management control. However, it does have disadvantages. For the smaller business, borrowed capital may not be readily accessible.

In particular, it can be difficult to borrow small amounts. It has become a truism that it can be far easier to raise sums in excess of $1m than it is to raise $10,000. For small sums, entrepreneurs often need to draw on their own resources or approach family or business associates for private equity.

Another consideration is how much different levels of borrowing affect the balance sheet. After all, the balance sheet conveys the assets set against ownership. If, for example, the level of debt starts to approach the level of investment, for instance, then ownership becomes distorted. In a sense, the creditors become akin to shareholders, because they control so much of the company.

A gearing ratio which sets borrowing at or around 20% of capital employed or of shareholders' funds is generally thought to be an acceptable level, as long as the source of profits and the trading environment are not seen as too volatile.

Interested parties, including potential future providers of funds, might want to look at income gearing, a measure of interest as a proportion of profits before interest, tax (and dividends, in the case of public companies). The smaller the percentage, the less vulnerable the company should prove to profit setbacks or bank rate increases.

One disadvantage of high gearing for quoted companies is that relatively high levels of debt can make stock appear high risk.

While safe stocks like utilities can service high levels of debt, less recession-proof businesses, like some high-tech areas, might find their market perceptions suffering if they consistently carry high levels of debt.

In some cases, it may look to the outside world as if the banks are paying the dividends.

That market perception is just as important for private companies looking to expand. Carrying too much debt at this stage in a business's life may actually increase the cost of capital, as creditors will want to see a higher return in exchange for a higher level of risk.

Finally, owner-managers or entrepreneurs looking to fund start-ups should bear in mind that there are some attractive alternatives to borrowing in the form of private investor funds and individual private investors or business angels, who can not only come to the rescue with finance, but, in some cases, prove to be invaluable sources of business expertise and experience. (Courtesy - ACCA, Sri Lanka)