The leverage decision is an important one that can have far-reaching consequences. The most basic leverage ratio is debt/equity and measures what percentage of your assets is financed with debt. The most fundamental advantage of using leverage is that it boosts returns, since you are using less of your own money (equity), and more of other people’s money (debt). Another advantage is of course the tax shields that it creates. The disadvantage is the possible distress costs caused by debt; due to the required and inflexible monthly payments, inherent is a risk of not generating the profits necessary to service your debt, which could lead to bankruptcy. The tradeoff theory (illustrated to the left) compares the benefits of leverage to the risks of distress costs.
How an Outside CFO Looks at It
The tradeoff theory is a great way to approach the leverage decision and is in the back of my mind when consulting clients. The key is that there is a middle ground that is different for every business. You want to use debt to your advantage to boost returns, but there is a very real risk of defaulting. I am often asked why I am so conservative while evaluating distress costs. Well, when you get in your car and drive somewhere, what are the chances that you will get into a life altering accident? Honestly, they are not very high. So why do we buckle our children into their car seats every single time? Because although the chances of getting into a life altering accident are very low, the costs associated with that accident if it does happen are exponential. The same is true for a company; evening though taking on just a little bit more debt doesn’t increase your chance of default all that much, the associated costs are high enough to promote a conservative approach. This shouldn’t scare you away from taking any debt, however; just remember that there is a balance.
Interest rates in Utah are currently comparable to the national average, which is at a record-setting low. Although there has been a good amount of speculation about the Fed raising rates, it is still a prime time to take advantage of low rates. Take some time to evaluate your current capital structure and feel free to reach out to Preferred CFO to learn more about how we can help.