12 Debt and Leverage
A Primer on Risk and Reward
If a company need money, what are its options? It could raise cash by issuing shares or debt. Shares are equity, so issuing shares means that the new shareholders will have ownership of the company. These new shareholders would probably be able to vote and have a say about company operations. We have already discussed the equity section of the Statement of Financial Position and looked at transactions on the Statement of Changes in Equity. This chapter focusses on debt: its characteristics, how interest works, and how debt can work for a company.
Let’s pretend that you own Daisy Ltd., a small retail company with a fiscal year end of 31 December. Business is booming and you’d like to expand to keep up with demand, but you don’t have enough cash saved up. You see two possible options:
- find an inventory to buy shares of your company, or
- take out a loan to finance expansion.
After some consideration you create a pro and con list to make your decision:
| Issue Shares | |
|---|---|
| Pros: | Cons: |
|
|
|
|
|
|
| Get a Loan | |
|---|---|
| Pros: | Cons: |
|
|
|
|
|
|
You carefully weigh the risk and reward of each option. There is a risk that you won’t be able to meet the contractual obligations of the loan: interest payments, PrincipalPrincipal:
The loan amount borrowed that must be repaid. The principal on a bond is called face value. payments, or debt covenants. But you believe the expansion will reward you with high returns, and you don’t want to share your hard-earned profits with another shareholder. In the end, you believe the return on the expansion will be 10%, while your bank’s small business loan bears an interest rate of 6%. So you expect that debt will be a more economical option for your company. After much contemplation, you approach the bank for a loan.
Tell Me More
Interest Payments are periodic payments paid to the lender. Usually these payments are made monthly, semi-annually, or annually. Interest is calculated as the principal amount of the loan multiplied by the interest rate.
Principal payments: any cash borrowed must be paid back. Principal payments may coincide with interest payments or may not be paid until the very end of the loan period, depending on the type of loan. Loan types are discussed in the next section.
Debt covenants are agreements between the lender and borrower specifying financial statement ratios that a company must maintain. If debt covenants are not met, the lender can make the borrowing company repay the debt immediately. Debt covenants reduce risk for the lender by making sure the company borrowing money is financially stable and can pay back the debt with interest as it comes due.
Interest rate: the rate used to calculate interest payments on loans as: principal owing x interest rate. The interest rate on a loan is always an annual rate. If interest is paid
annually, this is not a problem. But if interest is paid semi-annually or monthly, a company first has to express the interest rate on the same basis. For example, a 12% (annual) interest rate can be expressed as 6% semi-annually (12% x 6/12 months) or 1% monthly (12% x 1/12 months).