Leveraging Equity Capital with Debt
Sometimes, accountants need to leverage equity capital with debt. Suppose a business has $10 million in total assets (you find assets in the balance sheet of a business). This doesn’t mean that it has $10 million in owners’ equity. Assuming the business has a good credit rating, it probably has some amount of trade credit, which is recorded in accounts payable and accrued expenses payable liability accounts. These are non-interest-bearing liabilities that originate from the normal operations of the business.
Let’s say that the business’s accounts payable and accrued expenses payable liabilities total $3 million. This leaves $7 million to account for. It’s possible that all $7 million is provided by equity capital (that is, the sum of money invested by its owners plus the accumulated balance of retained earnings). But more likely, the business borrowed money, which is recorded in notes payable and similarly titled liability accounts.
The basic idea of borrowing money is to leverage the owners’ equity capital. For example, suppose the $7 million is split between $2 million debt and $5 million owners’ equity. The business has $2 debt capital for every $5 equity capital. The business is leveraging, or building on its equity capital; it’s using its equity capital to increase the total capital of the business. How much debt should a business take on?
Some businesses depend on debt for more than half of their total capital. In contrast, some businesses have virtually no debt at all. You find many examples of both public and private companies that have no borrowed money. But as a general rule, most businesses carry some debt (and therefore have interest expense).
The debt decision isn’t strictly an accounting responsibility — although after the decision to borrow money is made, the accountant is very involved in recording debt and interest transactions. Deciding on debt is the responsibility of the chief financial officer (CFO) and chief executive officer of the business. In medium-sized and smaller businesses, the chief accounting officer (controller) may also serve as the CFO. In larger businesses, two different persons hold the top financial and accounting positions.
The loan contract between a business and its lender may prohibit the business from distributing profit to owners during the period of the loan. Or the loan agreement may require that the business maintain a minimum cash balance. Generally speaking, the higher the ratio of debt to equity, the more likely a lender will charge higher interest rates and insist on tougher conditions, because the lender has a higher risk that the business will default on the loan.
When borrowing money, the president or another officer in his or her capacity as an official agent of the business signs a note payable document in favor of the bank or other lender. In addition, the bank or other lender may ask the major investors in a smaller, privately owned business to guarantee the note payable of the business as individuals, in their personal capacities — and it may ask their spouses to guarantee the loan as well.
One way of doing this is for the individuals to endorse the note payable instrument. Or a separate legal document of guarantee may be used. In any case, the individuals promise to pay the note if the business can’t. You should definitely understand your personal obligations if you’re inclined to guarantee a note payable of a business. You take the risk that you’ll have to pay some part or perhaps the entire amount of the loan from your personal assets.