‘Since the banking crisis, many companies are aiming to become debt free. But debt is a cheap form of finance, so what should I recommend to my CEO?’
The tax benefits of debt interest payments, according to the theory at least, make debt a relatively cheap form of finance.
So if your organisation is profit making, and those profits are taxable and your tax jurisdiction treats interest paid on debt financing as tax deductible, then debt is probably significantly cheaper than raising equity finance.
However, the 2008 financial crisis and ensuing period of slow growth have left many banks unwilling to lend, while some companies are averse to borrowing and don’t want to depend on the banks for financing new projects.
Indeed, many are now hoarding hefty cash reserves. For some, this is not a new phenomenon. Mastercard, Amazon and Apple have all famously issued zero debt, but in 2012 several previously indebted companies followed suit.
In the UK, building giant Persimmon announced its intention to remain largely debt free, in the medium term at least. But moving away from having incurred debt from borrowed capital towards becoming debt free is challenging.
Your CEO and CFO need to have a detailed knowledge of the company’s finances. Without a thorough understanding of costs and expenditure, as well as the business’s real profitability, the liquidity risk will be high.
They must also ensure your organisation has and is using an operations budget, implemented alongside a comprehensive cash flow management strategy.
The process will require a holistic operational rethink if the company is going to pay off existing debt by reducing costs and increasing cash flow.
Despite these challenges it is worth remembering that during periods of slow economic growth, the less debt an organisation holds the more likely it is to survive the storm.
And when economic growth kick-starts, debt-free organisations will be optimally placed to exploit new opportunities.
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Interest rates are low because of the low confidence that both businesses and consumers have in the economy.
The government believes that low interest rates are a “good thing” as they enable companies to borrow more easily, despite the fact that it was over-leveraging by business, consumers and, above all, government policy itself that got the UK into its current mess.
As the economy continues to stumble, it would appear that we are in a low-interest regime for a long time to come. But in this gloomy environment, fortune can favour the brave.
It really depends on the prognosis for your company. If you have opportunities to grow profitably – for example, by expanding the sales force, accelerating R&D spend or making an acquisition, which require additional funding – the taking on of manageable debt is no bad thing.
However, you always need to plan for the worst. Ensure that you are always in a position to repay the interest and the principal, if necessary.
You do not want to be beholden to the bank, however rosy the current prospects may appear. And ensure that you maintain a good working relationship with the bank so that if problems do arise, the bank is not caught unawares and issues can be solved together.
It constantly surprises me just how many businesses give no thought to maintaining what is a crucial relationship.
But do not look at plain debt in isolation. Look to other sources of capital, such as invoice or asset financing, which can be better alternatives for many businesses.
And do shop around. Banking is gradually becoming more competitive so it is worth shopping around for debt in the same way as you would for any other important supplier.
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