Debt

Borrowing money can be harmful at times, and helpful at times. Debt can be harmful if causes an
overabundance of risk or if it gets in the way of running the business. Debt can be a good thing if it
means that owners can use their money for other things that are more beneficial. It can be a good thing
if it means that the business can grow more quickly or accelerate the path to success. And it can be a
good thing if it helps the business manage risk. We will need to talk about each of these but let’s build
some context to illustrate what debt does to the financial results of a business.
You want to start a business but have a limited amount of money. If you want, you can continue to
build the business slowly and invest what you can, in other words only what the business earns over
time. This is called an internal growth rate which is estimated as a company’s Return on Assets (or ROA)
divided by (1-ROA). For example, if you have assets of $50,000 in the business, and the business earns
income of $6,000, then the business has an ROA of 6000 / 50000 = 12%. The maximum the business can
grow – or the internal growth rate – is therefore estimated to be: 12% / 88% = 13.6%. Note that this
assumes that you keep the entire $6,000 and reinvest it into the business. What does this have to do
with debt? Let’s say you want to grow faster than 13.6%. You decide to borrow $4,000. What does
this do to the growth rate? You will now have a total of $10,000 to invest into growing the business, the
$6,000 the business earned plus the $4,000 you borrowed. But your assets have gone up by $4,000 as
well (this is the borrowed cash). So the revised calculation is now: 10000 / 54000 = 18.5%, which you
now divide by (1-18.5%), and end up with 18.5% / 81.5% = 22.7%. So what did the borrowing do to
enhance growth? Previously, using ONLY internally generated funds from the business, you could grow
at a maximum of 13.6%. With borrowing, you can grow at a maximum rate of 22.7%. So your growth
rate has increased by about 67%! [calculation: (22.7-13.6)/13.6 = 67]. Not coincidentally, this matches
the increase in available funding…$4,000 of borrowing / $6,000 previous funding available = 67%. This
was a very long-winded way of illustrating how growth can enable higher rates of growth.
The existence of debt can also magnify the financial results of a business. Let’s start with one of the
most common success metrics used, a company’s Return On Equity (or “ROE”). ROE is simply net
income divided by equity. In other words, what did a company earn on behalf of its owners? If a
business has net income of $5,000 and has equity of $50,000, then the business has an ROE of 10%. One
of the problems with using ROE is that it doesn’t really help us understand why the business is successful
(or not!) financially. For example, is a business controlling its costs well or promoting an effective
differentiation strategy? Is a business utilizing its assets to the fullest capacity? And I’m going to add
another layer – what if the business decides to use less equity in its financing structure and more debt.
What will that do to the financial results? Let’s stick with this example and say a business has NO DEBT,
and the following financial information:

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 Sales: $100,000

Net Income: $5,000

Total Assets: $50,000

Equity: $50,000
Debt: $0

How is this business doing financially? As we saw previously, the business has an ROE of 10% [net
income/equity]. But we can break this “final score” into three pieces to get additional information [this
is sometimes called the DuPont decomposition or analysis of ROE].

First, a company’s net profit margin is a measure of what a business gets to keep after all its costs are
deducted from sales, in this case the net profit margin calculation is net income / sales, or
$5,000/$100,000 = 5%.

Second, a company’s total asset turnover is a measure of whether a business is fully utilizing their assets
over time, and in this case the total asset turnover calculation is sales / total assets, or
$100,000/$50,000 = 2.0.

Third, a company’s financial structure comes into play. This company has $50,000 of assets and $50,000
of equity, which means that the business has no debt. In other words, it used equity financing to
purchase all of its assets. So the equity multiplier calculation is total assets / equity, or in this case
$50,000/$50,000 = 1.0.

How do these things relate to one another? Remember that the ROE for the business is 10%. And this is
exactly what we get when we multiply the other three metrics together: 5%*2.0*1.0. In other words,

Return on Equity = Net Profit Margin * Total Asset turnover * Equity Multiplier

10% = 5% * 2.0 * 1.0

Generally, for ROE, a higher return is considered better financial performance. We can now observe
how the ROE got to be at 10%. The business had a profit margin of 5%, meaning for each dollar of sales
the business gets to keep five cents in profits after all costs are considered. And the business had an
asset turnover of 2.0 which means the asset base of the business was able to support twice its size in
sales. And the business had no debt, so its equity multiplier was 1.0.
Now comes the fun part. What if your business was financed with 50% equity and 50% debt, instead of
ALL equity. Would this change your financial results? Let’s keep it simple to start. The number most
impacted would be the equity multiplier. As a reminder, the calculation is total assets / equity. Before,
you had:
Total Assets: $50,000

Total Equity: $50,000

Equity Multiplier (before): $50,000 / $50,000 = 1.0

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If you go to 50% equity, 50% debt, the new structure would be (note that your assets do not change,
ONLY how those assets are financed!):

Total Assets: $50,000

Total Equity: $25,000

Total Debt: $25,000

Equity Multiplier (after): $50,000 / $25,000 = 2.0

So how would this change your Return on Equity? We know that we can multiply net profit margin *
total asset turnover * equity multiplier, so we would go from:

Return on Equity OLD = Net Profit Margin * Total Asset turnover * Equity Multiplier OLD

10% = 5% * 2.0 * 1.0

TO:
Return on Equity NEW = Net Profit Margin * Total Asset turnover * Equity Multiplier NEW

20% = 5% * 2.0 * 2.0

In sum, the ROE of the business doubles from 10% to 20% by modifying only the financing structure of
the business. In other words, the existence of the new debt magnifies the financial results of the
business – it acts as a lever, which is why “debt” is also called leverage. Now, to be fair, when you take
on the additional debt, you will have new interest expenses that will reduce your profit margin. By how
much could profit margin decline before you end up worse off than you were before?
Return on Equity = Net Profit Margin * Total Asset turnover * Equity Multiplier NEW
10% = ??? * 2.0 * 2.0

If you create an algebraic equation out of this mess, you get 0.10 = net profit margin * 2.0 * 2.0, and
solve for net profit margin, you end up with 0.025, or 2.5%. In other words, so long as increasing debt
doesn’t result in a margin lower than 2.5%, you will technically be better off with debt than without it. I
use the word “technically” because there are additional side effects that go along with debt that we
need to chat about.

So summarize so far, borrowing can improve the potential for growth and may improve your financial
results. So what’s not to like?
Well, borrowing can increase the risk for your company. If the new interest expense cannot be paid,
then that’s going to result in a problem. And magnifying a company’s financial results can work against
you if you are losing money. In the above example, we had something like:

Return on Equity NEW = Net Profit Margin * Total Asset turnover * Equity Multiplier NEW

20% = 5% * 2.0 * 2.0

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Well, what if your net profit margin turned negative? If you had a profit margin of -5%, then the ROE
would be:

Return on Equity NEW = Net Profit Margin * Total Asset turnover * Equity Multiplier NEW

-20% = -5% * 2.0 * 2.0

In other words, the ROE would be NEGATIVE 20%...not too good. If you had stuck with all equity, then
the ROE would still be negative, but not as bad.

A few other things to note. If the existence of interest expense (remember, these MUST be paid) causes
your business to really adjust how you do business to make sure you always have cash on hand, it can
reduce your operating flexibility. The counter-argument can be made that the existence of a predictable
cost may inhibit excess spending. In other words, debt can create a more careful and disciplined
operating environment.
We should also return to some basic borrowing terminology, using some examples. We know that when
we borrow, we have to pay back the loan. And the longer we borrow, the more interest we have to pay
over time. So say we borrow $60,000 at a 10% interest rate for three years. The cash flow timeline
looks like, for a plain vanilla borrowing arrangement:
Time: 0 1 2 3

Cash: +$60,000 ($6,000) ($6,000) ($6,000)

($60,000)

From the borrower’s perspective, you receive the proceeds from the loan immediately, and the principal
balance of the loan is $60,000 [note that the proceeds and principal balance may be different if there
are fees or other items that would cause the proceeds to be a bit higher or lower than the principal
balance]. Then you pay 10% interest on the principal balance each year, 10% * $60,000 = $6,000. This
interest payment is also sometimes called the coupon payment. Then you repay the principal balance at
the maturity of the loan, in this case three years. For this loan, the interest rate is fixed. But for some
loans, the rate can be floating. That is, the interest rate rises and falls according to some other external
factor, like the government raises or lowers interest rates, or you do something to increase or decrease
the risk of the business. The terms have to be predetermined so you know in advance whether it is
possible for the rate to rise or fall and by how much over time.

Instead of a plain vanilla borrowing arrangement, some loans are amortizing. For these loans, you pay
extra each year and the principal balance declines over time. Normally, therefore, the annual payment
is fixed. For our $60,000 loan, let’s say we fix the payments at exactly $24,127 per year (don’t worry at
this stage how we get this specific payment). Here’s how the cash flow timeline for this loan would
work:

Time: 0 1 2 3

Cash: +$60,000 -$24,127 -$24,127 -$24,127

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How does this work? Essentially, you still pay 10% interest per year, but only and always on just the
outstanding principal balance of the loan, which will change over time.

So, for year 1, the beginning principal balance is $60,000 and you will therefore need to pay $6,000
(10%*$60,000) in interest. So, any amount you pay above the $6,000 that first year will be used to pay
down the principal balance. Since you are paying $24,127:
$6,000 allocated to interest payment

Year 1 Payment: $24,127

$18,127 allocated towards paying down principal

So where do you stand at the end of the first year? Well, at the start, you borrowed $60,000. During
the year you made a large payment, some of it went towards interest, and the rest towards principal.
So the outstanding balance at the end of the first year will be $41,873 [calculation: $60,000 - $18,127].

You make the same payment of $24,127 at the end of the second year. How much will go towards
interest, and how much would be applied towards the remaining principal balance? Remember that the
interest rate of 10% is still relevant but you only pay interest on the year 2 starting principal balance of
$41,873. So the interest portion of your payment will be 10%*$41,873 = $4,187. So your year 2
payment breakdown will look like:

$4,187 allocated to interest payment

Year 2 Payment: $24,127

$19,940 allocated towards paying down principal

Essentially, since you paid off some of your loan the first year, there is less interest to pay the second
year, so more of your payment will go towards paying down the principal balance! What will be the
balance of your loan after two years??? Recall that the principal balance on your loans after year 1 was
$41,873. During year 2 you paid down the principal balance by $19,940. So the balance on your loan to
start the third year will be $21,933 [calculation: $41,873-$19,940]. And next question, how much
interest will you owe during the third year of the loan? Now that we know the principal balance of
$21,933, and recall that the interest rate is still 10%, the interest we will need to pay during the third
year is $2,193. So how will your year 3 payment break down [remember your total annual payment
stays the same in an amortizing loan with a fixed rate, in this example $24,127]?

$2,193 allocated to interest payment

Year 3 Payment: $24,127

$21,934 allocated towards paying down principal

So, where do you stand at the end of the third year? Recall that the balance of the loan after the second
year was $21,933. And you paid $21,934 towards principal during year 3 – so you’ve effectively paid off

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the loan! Note that you actually paid a little over the remaining principal balance, and that’s because
we rounded some of the calculations so we’re a bit off on the exact timing. You would really adjust your
final payment to be $24,126 and this would make the math work, or make all three payments exactly
$24,126.89 [instead of $24,127]. The main point here is that this is a different type of loan where the
principal balance is paid over time rather than waiting until the last year of the loan’s life. Amortizing
loans tend to be used when the proceeds are used to purchase an asset such as a house or a car (this is
called “asset-backed lending”, but not necessarily.

Using the table below to summarize our payments breakdown you will notice that, over time, amortizing
loans re-allocate the proportion that gets paid towards interest vs. principal. During the first year, the
interest proportion is at its highest point and what is paid towards principal is at its lowest point. By the
time the loan is in its final year, the interest is at its lowest point and the principal applied is at its
highest point.

Year Payment Interest Portion Principal Portion

1 24,127 6000 18127
2 24,127 4187 19940
3 24,127 2193 21934
Totals: $72,381 $12,380 $60,001

To give you an example of how extreme the principal and interest allocation can become, say you buy a
$400,000 house at a 5% interest rate and make the payments monthly over thirty years. Your monthly
payment would be roughly $2,147 for each of the 360 payments you will make over the next thirty
years. For the very first month, when you make your initial $2,147 payment, a whopping $1,667 will go
towards interest, and only $480 will be applied to the principal balance. Over the life of the loan, this
will gradually flip so that during the final years and months of the loan’s life, most of the payment will be
applied towards principal and less and less towards interest.

You should also know that there are other flavors of loans. Some may not have a stated maturity (like a
credit card) or you may have an arrangement called a “line of credit” where you have a maximum
amount you can borrow, and this line of credit balance rises and falls over time, and you only pay
interest on the outstanding balance each period. Then at some point the loan can get converted into an
amortizing loan. Or you may have a “securitized” loan, which means that when you borrow you pledge
assets as collateral against the loan. This just means that if you have trouble paying the loan, the lender
can seize the asset. The opposite type of loan is called a “debenture” which is just a situation where you
borrow without any security or collateral. Not surprisingly, securitized loans tend to have lower interest
rates than debentures.

Finally, you may elect to borrow at several points in time, and therefore a hierarchy needs to be
established in order to establish which loans are first or last in line if your business has a problem. Loans
that will be paid back sooner are considered “senior” to those that are paid back later or less and are
thus considered “junior”. So the least risky loans to the lenders are senior and securitized. The most
risky loans to the lenders are junior debentures. And these loan features will help drive the interest
rates you ultimately pay.

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