If a company has debt, is it a bad thing?

Julie Brownlee, Fsp Invest, 09 Jun. 2014

Tags: debt, company debt, gearing, companies and debt, shareholders, investment, investing,

If you’re looking for a company to invest in and come across one with debt, what should you do? Should you ignore this company as a potential investment? Or should you invest? Let’s take a closer look at companies and debt…

Debt can be advantageous to a company

In many circumstances, if companies didn’t take on some form of debt, they can’t pay for expansion, for instance. And debt can actually be advantageous to a company.

A company will borrow cash as it’s a cheap way of financing, Tim Bennett in Money Week explains. A company can put up an asset as security and in doing this can get a lower interest rate.

But when a company borrows money, there are consequences. For example, a company must pay its interest payments and any other debt costs before it can pay out any money to shareholders.

And if a company hits hard times and goes bust, it must clear its debts first before shareholders get anything back.

Lenders have the security of this knowledge when they lend money to a company. And this means it’s generally cheaper to borrow money from a bank than issue more shares and raise the cash from shareholders instead.

Gearing can benefit a company and its shareholders

But that’s not the only reason why companies borrow money. A company can benefit from the gearing effect of borrowing.

Let’s illustrate this with an example…

Take two companies. They both have net assets amounting to R100 million.

Company A is funded 100% by shareholder equity. In other words, the shareholders provided this R100 million.

Company B is funded 50% by equity and 50% by debt. The debt comes with a 10% interest rate on it. So shareholders provided R50 million and the remaining R50 million is from the bank.

*********** Best seller *************
The single greatest trading secret you’ll ever come across

It requires NO effort, ZERO skill, and NO hassle...

Set this up now, and you could have your first pay out in your hands in the next few days.

Click here to get in on this TODAY!

In a year, both companies make R50 million profit. That brings each companies’ net assets to R150 million.

If you sold both companies for the value of their balance sheets it’s a different story. Company A makes its shareholders a profit of 50%. But Company B makes its shareholders a profit of 100% as they only invested R50 million to start with.

So there you have it, why company debt isn’t necessarily a bad thing.

Related QA

d.c.heger asked:
MY QUESTION IS – I bought Bitcoin & Etherium some time ago – at first they grew nicely but now they are lower than what I paid for them. Should I [read more]
Published at 04 Apr. 2018 in: Investing 5 shares due to rocket 1 Answer
kavesh.maharaj.73 asked:
Hi Josh. I would like some advice on TFSA. I can get an interest rate of 7.8% nominal at a bank if I invest the R33k upfront in a fixed deposit [read more]
Published at 19 Mar. 2018 in: Investing Tax free savings vehicle 2 answers
kavesh.maharaj.73 asked:
Hi Josh Quantum wants to buy back shares from shall investors at what I think is a low price of around R3.86. You tipped the share in February [read more]
Published at 14 Mar. 2018 in: Investing Real wealth 5 answers
elizastrydom asked:
Hi Timon I am interested in registering for your Red Hot Storm Trader service. I am already a Red Hot Penny Shares investor. My question is [read more]
Published at 28 Feb. 2018 in: Investing Trading platform and broker 1 Answer
ManuE asked:
I have an interest in investing in Bitcoin, I just don't know how. If I buy Bitcoin with R15 000, how much can make (Return On Investment)? [read more]
Published at 25 Feb. 2018 in: Investing Investment 1 Answer

Related articles:




Youtube Twitter Facebook

Connect with us:    

  • Accelerated Investor
  • Accessories