Debt is defined as a set of payment obligations that a company has with banks or creditors or different suppliers, in other words, to owe money to someone because they have lent it or has provide services which you have not yet paid it.
Owe money to someone has its drawbacks and its advantages. Beginning with the drawbacks, it is common for the employer to consider that debt is a negative aspect for a company because it is certain that when a company is in debt and has to face its debts regularly, it must generate enough cash to cover those payments . That is, the risk of financial failure has been added to business risk. In addition, the debt reduces the financial flexibility of the company and may involve agency costs, understood as poor decision-making due to being in debt or needing to borrow to address interesting business opportunities.
Agency costs are caused by a conflict of interest between the shareholders and bondholders of a company, so that excessive indebtedness causes distortions in the investment policies that can cause a loss of value of the company. Example: invest in projects of low profitability or not provide capital to good projects.
On the other hand, it also has its advantages:
- It is a cheaper source of financing than that of the shareholders.
- The interests of the debt are tax deductible, they represent a fiscal shield.
- Indebtedness imposes discipline on managers (entrepreneurs or executives), that is, when money is not left over, decisions are made with greater caution, which avoids the excess of optimism and lightness in investment decisions or assumption of commitments. expenditure.
- It is a positive symptom of the trust that third parties outside the company have about the company’s ability to generate money and meet their financial commitments.
- If the company’s performance is positive, the debt increases the profitability of the shareholder since the latter has greater funds for the development of the business in relation to the invested capital.
Therefore, financial indebtedness can become a competitive advantage as a leverage factor to boost business growth, as long as the cost of debt is less than the weighted average cost of capital, it is a non-emotional technical issue.
Business indebtedness, in principle, is not bad. Now, as our illustrious writer D. Francisco de Quevedo Villegas would say: “the greatest evil is not duty, but not to fear not to pay”.
Therefore, lending to a company that before a time of adversity had no qualms about failing to meet its financial commitments, of course, is not the most advisable from the perspective of the investor or lender.
The question is what this debt is asked for:
- If it is to finance or cover losses that are dragged from previous years.
- If it is to finance investments that generate cash and value.
In the first case, the probabilities of default are much higher than in the second of them.
In either case, what is fundamental is the harmony between the capacity to generate cash and the service of the debt, understood as the payment of the debt and its interests.
If the lenders are willing to give us their money, it is because they trust in the good work of the company.
And it is worth asking: how can money be generated to meet financial commitments?
In several ways:
- The most positive and logical, through the company’s own activity, that is, income minus expenses translated into collections minus operating payments.
- The application of efficient collection and payment policies. That is, the improvement of their operational fund needs.
- The sale of productive assets or not of the company. For example, through a lease-back.
- The increase in debt, that is, replacement debt.
- The contribution of its partners.
In conclusion, the important thing is to know if the debt can be paid, if there is capacity to pay and the purpose of the debt, that is, what destination we are going to give it.