How much debt should a company have?

Not a Dirty Word: How Companies Use Debt to Improve Their Bottom Line

Does A Highly Leveraged Man Risky To Marry?

Having an optimal balance of debt and equity can help maximise returns, enhance growth and provide a competitive edge


By EUGENE TSE AND GENEVIA WIJAYA NG

HAVE you ever wondered what level of debt your company should take on? It's a seemingly simple - but integral - question that needs to be addressed in every business. Having an optimal balance of debt and equity can help maximise returns, enhance growth and give a company a competitive edge.

Imagine a young enthusiastic entrepreneur, the owner of a fast-growing private company and the chief executive of a listed company. How do they go about getting the funds needed to finance growth? All three are open to different financing options and are going to adopt different capital structures. There are generally three stages in the life cycle of a company. And the financing available at each stage is quite different (see graph). For example, a start-up is not likely to get bank finance due to its limited cashflow track record.

There are only two generic financing options - debt and equity. Debt financing through bank loans is perhaps the most common way of raising capital. Banks charge interest and the loan is typically secured by collateral with personal and/or corporate guarantees. Sometimes, companies may also take loans from shareholders, directors or other companies.

Pros and cons of debt

Equity financing, on the other hand, is when investors inject capital into the company in return for an ownership interest in it. While equity financing is more commonly used by listed companies, private companies can use it too. Investors providing equity financing may be personal contacts of the entrepreneur - such as friends and family - or professional investors such as private equity funds and angel investors.

Debt and equity financing each have advantages and disadvantages that should be considered to match a company's needs.

The main disadvantage of traditional bank debt is that it exposes a company to insolvency risk. Banks are in the business of lending, not investing. As most people know, banks typically do not take on risk with shareholders. Banks evaluate the credit risk before approving a loan. And to further reduce their risk, they often secure the loan with collateral as well as personal guarantees from shareholders.

During an economic recession, it is not uncommon to see our fair-weather banking friends withdraw loans to protect their capital, causing companies to run into cashflow difficulties. This was what happened to quite a few companies during the recent global credit crunch. Fortunately for Singapore, the government stepped in to provide guarantees to make sure banks continued to support local companies.

With the credit crunch still fresh in people's minds, should entrepreneurs and CEOs stay away from debt completely? How much debt is too much? We will try to answer these difficult questions.

Let's start by looking at some of the advantages of debt:

It is a more affordable source of funds than equity. Increasing debt gives shareholders more capital and more capacity to generate cash flow and profits, thus increasing profit to shareholders or return on equity (ROE).

It acts as a tax shield, as interest is tax deductible while dividends are not. Debt financing can reduce a company's tax liability, which translates into a saving in real cash flow.

Because loans often come with debt covenants that companies have to adhere to or risk withdrawal of the funds, debt tends to instil discipline in a company's cash management system and its current ratios.

So if a company needs to raise, say, $5 million for expansion, should it go for debt or equity financing?

Banks are the most natural choice because they are easily accessible. If the banks reject a loan application, this suggests the company's credit risk may be too high, or the funding nature too risky - for example, overseas expansion. This is when management can approach private equity funds or angel investors. While fees and rates are higher, private equity funds will take risky investments in hope of making large upside gains.

As for 'how much debt is too much', we can refer to a study by Aswath Damodaran, Professor of Finance at New York University, as a guide. In this study, data was collected on different industries, including debt-to-equity ratio. From these 2010 statistics, the global average debt-to-equity ratio is 0.8, with the Internet software and services industry having the lowest debt-to-equity ratio of 0.028 and the banking industry having a ratio as high as 20.8. Although the ratio varies across industries, as a rule of thumb, according to the US Chamber of Commerce Small Business Nation, an acceptable debt-to-equity ratio is between 0.3 and 1.0.

Balancing of debt and equity is not a simple matter, so companies should engage professional advisers or use financial and risk models before making a decision.

Eugene Tse is a manager of corporate finance at BDO Advisory Pte Ltd and Genevia Wijaya Ng is an intern

Low Margins are bad. High Margins are good - Revisit

True or not?

Can investing be made so simple by thinking that all low margins are bad and all high margins are good? Then every Tom, Dick, and Harry can become good investors by looking at margins. In the real business world, it is not that simple. You have to go beyond it to fully understand how such companies have managed to survive with this business model over market and economics cycles.

It is somewhat similar to the ideas of "Low Sales Commissions are bad. High Sales Commissions are good." Marry The Guy Who Has 60% Sales Commission. Some low commissions salesmen may be paying high income taxes. Get it?

Low Net Profit Margin - Avoid Them? - Part 3

Low Net Profit Margin - Avoid Them? - Part 2

Most of the stalls in hawker centers sell fried fishcake at $1 per piece, but this stall at ChinaTown Hawker Center 2nd floor near the center's public toilet is selling fried fishcake at $0.50 per piece. Minimum order is 2 pieces.

I am pretty sure the margin per piece has been squeezed but they make it back by selling more. Last Friday, while I was there I bought 20 pieces.

Value for money and good taste. Uncle8888's Recommended one! $1 for 2. Shiok leh!

They have two stalls side by side. If you are only buying fishcakes, you don't join the long queue for yong tau foo; but go to the stall on the left.

Low Net Profit Margin - Avoid Them? - Part 2

Low Net Profit Margin - Avoid Them?

Bummy's comment

hum chim peng

Many years ago at the former Maxwell market, there was a hawker stall selling "hum chim peng" at 10 cents per piece (small version) while other stalls elsewhere were selling at 20 or 30 cents per piece (larger version).

It was quite obvious that the profit margin from selling "hum chim peng" at 10 cents per piece was much thinner.

Guess what happened to the customers' buying pattern of "hum chim peng" at this stall?

When the price of "hum chim peng" was only 10 cents per piece, customers didn't buy a few pieces; but they bought in units of 10, 15 and 20 pieces.

I usually bought 10 pieces and ate a few pieces myself and the rest passed around to colleagues as treat. May be psychologically I didn't want to be seen as cheapskate so I bought more.

If the "hum chim peng" was 30 cents per piece, I would just buy enough for myself.

This hawker was able to move massive volume of his product to make up for the razor thin margin. The only difference was that he got to work harder.

Low Net Profit Margin - Avoid Them?

Some retail investors hope to find good companies which are cash rich, high dividends payout, high net profit margin and high growth companies. Such thinking is no different from some young women dreaming of finding young husbands who are cash rich, no vices, high income earners, and have bright future.

What will be your advices to these women?

Is Your Company Hoarding Too Much Cash For You? - Part 4

Highly Leveraged Blue Chips - Avoiding Them Like Plague?

Should you also avoid companies with low net profit margin like shit?

You should look closely at the nature of business before advising people to totally avoid companies that operates on low margin as you may potentially miss your chances of taking some nice profit off the table.

For example, in 2009, the top five best performing STI component stocks are as follows:

1) Noble Group, +218.6%
2) Genting Singapore, +201.9%
3) Jardine C&C, +184.2%
4) Golden Agri, + 145.7%
5) Olam Intl, +131.3%

Noble and Olam are both low net profit margin companies but if you are early investors you are laughing to the banks.

It is not necessary that a company must have a high net profit margin; in fact, in some industries it is better not to. For example like grocery stores, it is important to move a massive amount of volume. To do this, the grocery stores must reduce their profit margins to as low as possible.

Keep in mind that a high net profit margin does not correlate to large profits. If the company cannot move their product in large quantity, it does not matter what the net profit margin is, they are not going to make lots of money. Basically, the net profit margin is telling us how much markup, after all costs and expenses, there is in the companies business model.

It is perfectly acceptable to have a low profit margin with a very fast inventory turnover and massive amount of volume and that may translate to huge profits.

What is your advice again to those women who are still waiting for their dream men?

Is Your Company Hoarding Too Much Cash For You? - Part 4

Is Your Company Hoarding Too Much Cash For You? - Part 3

Understanding cash flow

Cash flow is the amount of cash generated from all sources within a specific period of time. Cash can be generated by the following:

• from operations
• from owners’ equity
• from loans
• from investing
• from one-time activity such as an asset sale

A cash rich company does not mean it is a highly profitable company or its future earning growth is secured.

Cash flow and Profit is not the same. Cash flow is the money that flows in and out of the firm from operations, financing activities, and investing activities. Profit, also called net income, is what remains from sales revenue after all the firm's expenses are subtracted. Companies can make a profit but still have a negative cash flow and not be able to pay its financial obligation and soon run into serious troubles when more of their creditors becoming worry and demand debts settlement and more suppliers demand cash settlement upon delievery.

Cash rich just means that in the short term the company has very strong ability to meet its financial obligations meet payroll, pay suppliers, meet debt payments and make future dividend distributions to shareholders.

Some companies are rich cash due to more owner's equity, loan, or asset sale instead of accumulation of good cash from operations.

A good company may not necessary has to be cash rich; but it must have good net income, good cash flow from operations, good visibility of future earning growth and has been consistently returning excess cash to shareholders as dividends or special dividends instead of hoarding so much cash to become a cash rich company.

Highly Leveraged Blue Chips - Avoiding Them Like Plague?

There are good reasons why these companies are classified as blue chips while many other companies can't even smell it or worse some become blue-black chips.

Do you really need to avoid these highly leveraged blue chips like plague?

In 2009, the top five best performing STI component stocks are as follows:

1) Noble Group, +218.6%
2) Genting Singapore, +201.9%
3) Jardine C&C, +184.2%
4) Golden Agri, + 145.7%
5) Olam Intl, +131.3%

Noble and Olam are highly leveraged companies but they have Giants supporting them. If you are avoiding them like plague, you are missing the opportunity in making the most dollars in the least time.
 
Yes, they are risky companies so don't get greedy and over-weight them in your portfolio and get killed if things go wrong.
 
You have to be extremely careful and under-weight them in your portfolio to be conservative and safe.
 
But, do you really need to avoid these highly leveraged blue chips with Giants supporting them like plague?

Does A Highly Leveraged Man Risky To Marry?

Is Your Company Hoarding Too Much Cash For You? - Part 3

http://createwealth8888.blogspot.com/2009/11/is-your-company-hoarding-too-much-cash.html

Cash-22: Is It Bad To Have Too Much Of A Good Thing?

by Ben McClure

Cash is something companies love to have. But can they have too much of the stuff?

Provided things are going well, debt financing helps a company gear up to boost returns, but investors know the dangers of debt. When things don't go as planned, debt can spell trouble.

But what about a company's cash position? If excess debt is a bad thing, does it follow that a lot of cash is a good thing? At first glance, it makes sense for investors to seek out companies with plenty of cash on the balance sheet. After all, cash offers protection against tough times, and it also gives companies more options for future growth.

The Theories

Unfortunately, nothing is quite that simple. For investors digging into company fundamentals, a big pile of cash can signal many things - good and bad. How investors interpret cash reserves depends on how the cash got there, the kind of business the company is and what managers plan to do with the cash.

Corporate finance textbooks say that each firm has its own appropriate cash level, and companies ought to keep just enough cash to cover their interest, expenses and capital expenditures; plus they should hold a little bit more in case of emergencies. The current ratio and the quick ratio help investors determine whether companies have enough coverage to meet near-term cash requirements.

Theory also holds that any extra cash over and above those levels should be redistributed to shareholders either through dividends or share buy backs. If the company then discovers a new investment opportunity, managers should turn to the capital markets to raise the needed funds.

Good Reasons for Extra Cash

That said, there are often good reasons to find more cash on the balance sheet than financial principles suggest prudent. To start, a persistent and growing reserve often times signals strong company performance. Indeed, it shows that cash is accumulating so quickly that management doesn't have time to figure out how to make use of it.

Think of Microsoft. The software giant has done so well for so long that it built up a mountain of more than $40 billion. As revenues continue to grow, that cash pile will swell further. Other highly successful firms in sectors like software and services, entertainment and media don't have the same levels of spending required by capital-intensive companies. So their cash builds up.

By contrast, companies with a lot of capital expenditure, like steel makers, must invest in equipment and inventory that must be regularly replaced. Capital-intensive firms have a much harder time maintaining cash reserves. Investors should recognize, moreover, that companies in cyclical industries, like manufacturing, have to keep cash reserves to ride out cyclical downturns. Boeing or Daimler Chrysler, for instance, face high demand at one point in the business cycle and then face another phase when cash flow dries up. These companies need to stockpile cash well in excess of what they need in the short term.

Bad Reasons for Extra Cash

All the same, textbook guidelines should not be ignored. High levels of cash on the balance sheet can frequently signal danger ahead. If cash is more or less a permanent feature of the company's balance sheet, investors need to ask why the money is not being put to use. Cash could be there because management has run out of investment opportunities or is too short sighted and doesn't know what to do with the cash.

Sitting on cash can be an expensive luxury because it has an opportunity cost - the difference between the interest earned on holding cash and price paid for having the cash as measured by the company's cost of capital, or WACC. If a company, say, can get 20% return on equity investing in a new project or by expanding the business, it is a costly mistake to keep the cash in the bank. If the project's return is less than the company's cost of capital, the cash should be returned to shareholders.

Don't be fooled by the popular explanation that extra cash gives managers more flexibility and speed to make acquisitions when they see fit. Companies that hold excess cash carry agency costs whereby they are tempted to pursue "empire building". Top managers can fritter away cash on wasteful acquisitions and bad projects in a bid to boost their personal power and prestige. With this mind, be wary of balance sheet items like strategic reserves and restructuring reserves. They are often just excuses for hoarding cash.

Even worse, a cash-rich company runs the risk of being careless. The company may fall prey to sloppy habits, including inadequate control of spending and an unwillingness continually to prune growing expenses. Large cash holdings remove from managers much of the pressure to perform.

There is much to be said for companies that raise investment funds in the capital markets. Capital markets bring greater discipline and transparency to investment decisions and so reduce agency costs. Cash piles let companies skirt the open process and avoid the scrutiny that goes with it.

Conclusion

To play it safe, investors should look at cash position through the sieve of financial theory and work out an appropriate cash level. By taking into account the firm's future cash flows, business cycles, its capital expenditure plans, emerging liability payments and other cash needs, investors can calculate how much cash a company really needs

Does A Highly Leveraged Man Risky To Marry?

A highly leveraged man who has borrowed heavily from banks to finance his 25 global properties and he is making good money out of his properties. If you are a woman, would you marry him? Is he too risky and a potential bankrupt?


If I tell you that his father is the richest man in Singapore, would you still think that he is risky man and will not marry him?

Highly leveraged companies are risky only if they have difficulties in re-financing or unable to raise large equities without support from major rich shareholders.

http://createwealth8888.blogspot.com/2009/09/business-leverages-and-personal.html

Is Your Company Hoarding Too Much Cash For You? - Part 2

Someone said this in his blog:
Are my initial reasons for holding on to these stocks like: Huge cash reserves?

There is a saying: An Idiot and his money will soon part. Similarly, I will say: A Dumb CEO and the Company's huge cash reserves will soon part.

We may need to understand the perspective of CASH in a corporate environment. Cash is a just an instrument for the company for the purpose to:

• fund day-to-day expenses or in another word to manage a healthy cash flow.

• serve as cushion during bad times

• deploy excess cash as capital efficiently and effectively to fund future growth and to generate more cash.

Can investing be made so simple by just looking at a company's huge cash reserve? I wish too.


http://createwealth8888.blogspot.com/2009/10/is-your-company-hoarding-too-much-cash.html


Do you still see huge cash hoarding as a buy signal?

Is Your Company Hoarding Too Much Cash For You?

Is your company hoarding too much surplus cash and even at good times is also hoarding surplus cash? Good or bad?


I don't think this type of company is any good. Shareholders provide capital to the company and expect the Management and Board to efficiently deploy their capital into businesses to generate better returns for the shareholders and not to save their money in the banks on their behalf.

It is prudent for the company to hoard surplus cash to cushion the company during bad times. But, if the company has been habitually hoarding cash even in pretty good times, it telling us that Management is clueless on how to better deploy the excess capital and the company may have no real growth prospects and can only hoard cash in the banks. Or the company is deemed weak by the Capital markets and the Management knows that they have difficulties to tap into the Capital markets or to raise Equities from the potential investors so they have no choices but to hoard excess capital as cash cushions.

Strong companies with real growth prospects have no problems to tap into the Capital markets or raise Equities from the potential investors to build up cash reserve for strong balance sheet during bad times or to grow the company. The Management of strong companies with real growth prospects will never see the need to hoard excess capital as cash cushions.

So what have you been thinking if your company is helping you to save excess money in the bank? Still a good company? Hmm...

Not a Dirty Word: How Companies Use Debt to Improve Their Bottom Line

Published: February 04, 2009 in Knowledge@Wharton


Someday, the financial crisis will end and companies will get back to the routine business of raising capital to grow. Will they make smart choices about borrowing? Or will they fall back into habits experts have long seen as self-defeating?

To many laymen, debt is a dirty word, and plenty of companies have indeed been dragged under by shouldering too much. But academics and other experts have long believed the opposite is true: Many companies take on too little debt, failing to fully exploit benefits like the tax deductions on interest payments.

Now, a new study by three Wharton faculty members shows that companies are not, in fact, foolishly leaving tax deductions on the table. The findings, based on data compiled from thousands of firms between 1980 and 1994, should be especially valuable to outsiders -- such as lenders, analysts, institutional investors and shareholders -- trying to judge the wisdom of a firm's use of debt.

Previous studies have shown that many non-financial firms "are too conservative in their debt policies, meaning that they could increase their debt levels to reap substantial tax benefits without significantly increasing the risk to their financial health," said Wayne R. Guay, an accounting professor at Wharton and co-author of the paper, titled "Improved Estimates of Marginal Tax Rates: Implications for the Under-Leverage Puzzle." His co-authors are Wharton accounting professors Jennifer Blouin and John E. Core.

"Our paper shows that previous research substantially overstates the tax benefits that some firms could achieve by increasing their debt levels," Guay said. "Our results also suggest that most corporations appear to adopt debt policies that efficiently trade off the tax benefits [of debt] with the risks to financial health."

Companies have various ways to raise money, but the most prominent are borrowing through the issue of corporate bonds or raising equity by selling new shares of stock. By selling new shares, a company avoids taking on a debt that must be repaid with interest. But increasing the number of shares dilutes the value of those already in circulation, so shareholders often oppose this approach. Debt does not dilute shareholder value, but payments to debt holders can become a fatal burden if revenues fall short.

A Taxing Decision

Often, the company's choice comes down to federal tax issues: Interest on debt payments is tax deductible, while dividends paid to shareholders are not. For a company with no debt, the final dollar of earnings might shrink to only 65 cents once the corporate tax is paid. But if the company has a healthy dose of interest deductions from debt, that dollar may still be worth a dollar after tax time.

"The company is going to make decisions based on tax implications," Guay noted. If they make a given decision, "they want to know what is the present value of tax that they would have to pay on an extra dollar of profit, or an extra million dollars of profit."

For decades, the academic literature and marketplace have clung to a belief that many companies fail to take full advantage of debt, which, in addition to tax deductions, can increase profits by enlarging a company's bets. Investing a dollar at a 10% return produces a 10-cent profit. By borrowing an additional dollar and paying 5% interest on the loan, the profit can be boosted to 15 cents, up 50%. This process was behind the leveraged buy-out craze of the 1980s. Today, private equity firms use the same logic, Guay said.

"A major strategic objective of private equity firms is to buy under-leveraged companies and then leverage them up to gain the tax advantages," he noted. But this view may be mistaken. "With our research, what we feel comfortable saying is that the tax benefits of debt have been grossly overestimated in many cases."

Previous research exaggerated the benefits of debt because it underestimated the volatility of cash flows and earnings, according to Guay. He and his fellow researchers zeroed in on that factor, he added, noting that a company's borrowing issues are similar to a homeowner's. The home buyer who pays cash makes 10% if the home's value rises 10%, and loses 10% if the value falls by that amount. But if the homeowner puts only 10% down and borrows the rest, a 10% gain in price means a 100% gain in equity, and a 10% decline means a 100% loss.

"The leverage adds variance and volatility to any investment," Guay said.

Previous studies have assessed volatility by looking at historical data. But they generally measured ups and downs in dollars, because tax issues, such as progressive tax rates, are determined by thresholds measured in actual earnings rather than percentage returns. This approach to volatility can distort the picture, since a given dollar amount is less and less significant as a company grows over the decades, Guay said. He and his colleagues got a different view by, essentially, looking at volatility in percentage terms, showing that companies with lots of leverage were more volatile.

In years when income is low, the tax benefits from interest payments are smaller since the company's tax rate will be lower. But even if the company loses money, the interest-rate deductions have value, since they deepen losses that can be carried forward and used to reduce taxable income in subsequent years. Better understanding of the volatility of future earnings makes it easier to see how well a future tax deduction will pay off.

Guay's co-author Blouin cited the example of a start-up firm that has lots of debt and little or no revenue, meaning there is no taxable income. "They are generating interest deductions that don't do them any good today," she said. Previous research has underestimated the probability the firm will have losses in the future, she added. That makes the interest deduction carried forward seem more valuable than it may actually be, because it overstates the taxable income that the deduction can be used to reduce.

"Taxable income is subject to the winds of commerce, so there are all sorts of fluctuations that can happen," Blouin noted. For a clearer view of this, she and her colleagues grouped similar firms together in their analysis.

Like individual tax rates, corporate tax rates are on a progressive scale, with the rate rising as income goes up. Interest deductions have the most value when they reduce the income subject to the highest tax rate the firm pays. If the deduction is so big as to cut income to a level taxed at a lower rate, the deduction has less value. A deduction applied against income taxed at 35%, for example, would save the company 35 cents on every dollar of income, while a deduction against income in the 25% bracket would save just 25 cents.

The researchers identified the point at which the deduction started to lose value -- the "kink." They found that the firms they studied typically had just the right amount of debt to get the most out of their interest-rate deductions, while previous research that did not look as closely at income volatility had shown firms needed to more than double their debt loads to maximize their interest deductions.

"On average, firms are right where they ought to be," Blouin said.