Thursday, 22 April 2010

Risk of Loss Caused by a Company's Indebtedness

Companies that choose to finance a large proportion of their assets with borrowed money face an increased risk of being unable to meet their financial obligations.  The greater a company's reliance on debt, the more likely that the company will be unable to service the required interest and principal payments that come from debt.  A large amount of debt also tends to produce large variations in a firm's net income, which places the stockholder in a riskier position because it is more difficult to forecast earnings and dividends.

A company that relies mostly on earnings and owner contributions to pay for new assets has few fixed financial expenses to meet and is likely to be able to continue to meet its financial obligations when it encounters difficult economic conditions.

  • A business with a substantial amount of debt is likely to encounter difficulties when revenues decrease.  
  • Difficulties may also arise when revenues increase more slowly than the firm's management expected at the time the funds were borrowed.

If being in debt is so risky, why do most companies so readily employ this method of financing?  

  • The answer is that debt allows a company to acquire more assets and grow more rapidly than would reliance solely on earnings and stockholders' contributions.  
  • A company that conscientiously avoids borrowing money may have to delay its expansion plans because of the limited funds available to pay for new assets.  
  • Delayed expansion may allow the firm's competitors to gain an advantage by reaching new markets or developing new products first.  
  • A delay in expansion plans may also keep a firm from being among the first in its industry to reach a cost-efficient size.

Borrowing money rather than issuing additional shares of stock permits a business to expand without having to share control and profits with additional owners.  The firm also saves on future dividend payments.

  • A firm that borrows $500,000 avoids having to sell thousands of additional shares of common stock on which dividends are likely to be paid in the future even if no dividends are currently being paid.  
  • In addition, while dividend payments to stockholders must be paid from after-tax income, interest paid on debt is permitted as a deduction in calculating taxable income.  
  • In other words, the interest expense from borrowing results in a tax benefit for the borrower.

Another potential advantage of borrowing is that debt financing will allow a company that experiences favourable business conditions to earn a higher return on the stockholders' investment.

  • A decision to seek a long-term loan at a fixed rate of interest can prove to be a very wise decision if a company's productivity and revenues grow.  The fixed interest expense means that a substantial proportion of revenue growth is likely to flow down as profits for the stockholders.

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