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Borrowing money to grow a business can turn out to be very profitable, and it is a key part of our capitalist economy.

If a company can borrow money at, say, 5% per year interest, but can use the money to generate a return of more than that (perhaps by exploiting a new idea, or expanding into new markets), then it can cover its interest payments easily and still keep some extra profit for itself, making borrowing look like a good thing.

The other way a company can raise money, of course, is by issuing new shares, or equity. That way, the company gets new money without adding to its debt and without incurring interest charges, and the new investors get a slice of the company and its profits.

Debt vs Equity

Which way a company should turn when it needs cash to grow, either to debt or to equity, can be a tricky decision. There are advantages and disadvantages to both, as we can see if we invent a few scenarios.

Imagine a company with a current market capitalisation of £10m that wants to raise another £10m to expand, and that currently makes profits of £0.5m a year (that is, a 5% return). If it doubled the number of shares and sold the new ones at the current price, it would get the £10m and end up as a £20m company, and if it carried on making 5% its profits would double. The doubled profits would be distributed amongst twice as many shares now, so its earnings per share would remain the same.

If the company instead borrowed the £10m at an interest rate of 5%, it could again use the money to double its profits. But half of that profit now would need to be paid in interest, so the profit left for existing shareholders would remain the same. In one case the new shareholders would get the new profits, and in the other the lender would get it.

Geared returns

But let’s suppose the new £10m will net a £1m return — at 10%, twice the current rate. That’s an overall 7.5% profit on the combined £20m.

In the equity case, existing shareholders will see their profits grow from 5% to 7.5%, and the new investors will also get 7.5% on their investment. But in the debt case, of the total £1.5m return, the interest owed is still fixed at 5% of the borrowed £10m, which is £0.5m. That leaves shareholder with a £1m, or 10%, for themselves. So issuing new equity would raise existing shareholders’ profits by 50%, whereas borrowing the money would double their profit! Easy decision?

Well, suppose something goes wrong, and the new product line is delayed and doesn’t come to market in the following year, leaving the company with only its regular £0.5m return. In the equity case that is now split between twice as many investors, and all will see only 2.5%. But in the debt-financed case, the whole £0.5m is swallowed up in interest payments, and the shareholders won’t see a penny! And if the company made less than the £0.5m needed to service its debt, it would be in trouble.

The effect of borrowing to grow a business is known as gearing. If the company makes a better return from the new money than is needed to cover its interest payments, its profits are geared up disproportionately, but if it makes a lower return, its profits are geared down, sometimes becoming losses. So growth through borrowing has the potential to be more profitable, but that comes at the price of higher risk.

When assessing potential investments for ourselves, how do we assess the risk associated with a company’s borrowing? There are two measures that are quite handy.

Gearing and cover

A company’s gearing is often to be found amongst its published fundamentals, usually expressed as a percentage, by either dividing debt by equity (in which case our £10m company that borrowed £10m would have a gearing of 100%), or dividing debt by the total of debt plus equity (giving our example a gearing of 50%). It’s important to understand how a quoted gearing is calculated, but both ways here show us that 50% of our company’s employed capital comes from borrowing.

Another useful figure is a company’s interest cover, which tells us how well its returns are able to cover the interest it owes. If our company was a success and made that £1.5m return, that would cover its interest payments three-fold, so we’d see an interest cover of 3. But in the case in which the new earnings did not come online in time, the £0.5m return would give it an interest cover of just 1. Less than 1, and a company is in trouble.

What does it mean to you?

How much gearing you’re prepared to accept in a company you invest in is really a function of your risk tolerance, and people who like to take on more risk in the hope higher profits will be happy with higher gearing. But an economic downturn will hit geared investments a lot harder than others.

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This article contains general educational content only and does not take into account your personal financial situation. Before investing, your individual circumstances should be considered, and you may need to seek independent financial advice.  

To the best of our knowledge, all information in this article is accurate as of time of posting. In our educational articles, a "top share" is always defined by the largest market cap at the time of last update. On this page, neither the author nor The Motley Fool have chosen a "top share" by personal opinion.

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