How to Leverage Equity Capital with Debt
Leverage refers to the idea of using debt to add capital to your business. Leverage is a good strategy if the company can generate more in earnings than it pays in interest expense and fees on the debt. If a business is interested in leverage, the first consideration is how much of the balance sheet should include debt.
Suppose a business has $10 million in total assets. The balance sheet equation is Assets less Liabilities equals Equity. $10 million in total assets doesn’t mean that the company has $10 million of equity. You have to subtract liabilities from assets to compute equity.
Assuming the business has a good credit rating, it probably has some amount of trade credit extended for purchases, which is recorded in the accounts payable liability account. Other kinds of operating liabilities may also come into play. Suppose its accounts payable and other operating liabilities total $2 million.
At this point, you’ve identified $10 million in total assets, less $2 million in liabilities. That leaves $8 million to account for. The $8 million could represent other liabilities. Some of the $8 million may be equity. In a sense, you’re filling in the numbers in the balance sheet equation:
$10 million total assets – $2 million liabilities = $8 million to be identified (either more liabilities or equity)
Some businesses depend on debt for more than half of their total capital. In contrast, others 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 really an accounting responsibility as such; although once the decision is made to borrow money, the accountant is very involved in recording debt and interest transactions. Deciding on debt is the responsibility of the chief financial officer and chief executive officer of the business.
In medium-sized and smaller businesses, the chief accounting officer (controller) may also serve as the chief financial officer. In larger businesses, two individuals 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 is to charge higher interest rates and insist on tougher conditions. That’s because the lender has higher risk that the business may default on the loan. A high debt-to-equity ratio means the company has more debt for every dollar of equity.
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 to the lender. In addition, the 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 note payable as well.
The individuals may endorse the note payable, or a separate legal instrument of guarantee may be used.
The individuals promise to pay the note if the business can’t make payments. 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 may have to pay some part or perhaps the entire amount of the loan from your personal assets if the business is unable to honor its obligation.