The curse of leverage

When borrowing long-term debt, many business owners forget that the money has to be returned. At the loan′s expiration date they don’t have enough cash to pay the principal back.

I am not suggesting not to borrow, just reminding you that debt is not your money and has to be repaid.

Business owners who practice FIT in their companies get superior margin because they excel at combining the eight elements of the business puzzle. That allows them to build healthier business models with healthier balance sheets.

Much has been written about the optimal capital allocation. Scholars defend that it is convenient to have debt to increase the profitability of your shares, as it has lower cost than capital and helps to pay less taxes. This is technically correct. But in the real world, profits can change drastically from one year to the next as a result of a competitive shock (a new powerful competitor entering the industry by cutting prices) or a change in the economic cycle.

 If profits halve, what seemed a reasonable debt/profits ratio in a very short period of time inflates (debt 4 times EBITDA become 8 times EBITDA) and overnight your company becomes too leveraged, has difficulties to pay interest and risks going through Chapter 11. You will desperately need equity at the worst possible moment, when the company′s financial image is most damaged. Financial institutions will not be willing to renew credit. Investors will see it as a company under severe risk of bankruptcy, which will lower their perception of value and they will try to exploit the precariousness of a seller in need.

@EnriqueQuemada

www.onetoonecf.com