Debt has the ability to be both a positive and negative catalyst for wealth. Too much debt becomes out of control, too little debt and opportunities may pass by. Debt has been used as a financial instrument for centuries and is means by which lenders can make a profit and borrowers can 1) engage in financial ventures otherwise unfunded 2) increase standard of living and 3) allow businesses to finance activities more profitably. This article will focus on the use of debt as a potentially wealth building business venture.

Financial ventures and expenditures financed through debt can go very well or terribly wrong if the debt is unrealistic, cannot be paid back or does not create a return higher than the cost of debt. An example of beneficial debt leveraging is Coca-Cola’s use of “debt financing to lower the cost of capital, which increases return on shareholder equity” (Coca-Cola 10Q, 4Q 2007) In other words, the cost of debt is cheaper than other sources of capital for Coca-Cola company.

BUSINESS USE OF DEBT:

Businesses utilize debt to increase potential returns whether those returns be through expanded operations, more inventory, research and development, project development etc. It is not uncommon for businesses to use debt because business owners and directors realize the potential debt has in creating wealth. One need only look at the financial statements of the thousands of publicly traded companies to realize just how much debt is used to finance one or more aspects of a business. A few examples of business use of debt to generate profit are the following:

*Leveraged buyouts
*Debt funded price wars
*Increasing product quality
*Capital investments
*Vertical and/or horizontal integration

DEBT AS A TOOL FOR GROWTH:

Without debt, businesses are left only with liquid assets and equity. While assets and equity may be a wiser choice in a higher interest rate environment, there are some times in the business and economic life cycle in which debt may be a worthwhile risk for growth. For example, there may be times when a proven demand for a product is there, and market research has demonstrated both competitors and customers are fueling the supply and demand equation.

To illustrate the above point, if company A is a grower and seller of tomatoes however in order to expand its product line to include a greater variety of tomatoes it needs more greenhouse space. Company A decides to take on a debt of $10,000.00 at an interest rate of 7.5% to build the extended greenhouse and increase its product line to include hybrid tomatoes. Sales that spring increase 4 fold from 2000 tomatoes to 8000 increasing revenue from a monthly revenue of $10,000 to $40,000. In this example the debt paid off immediately and turned a profit.

DEBT FUNDED OPPORTUNITY:

There are many types of debt and also many types of debt funded opportunities. Depending on the nature of the business venture, and the debt markets, the potential benefits and costs of debt can vary. Debt can include business credit cards, vehicle and equipment loans, property mortgages, lines of credit etc. and the opportunities that debt can make possible also differ, a few of which are provided below:

*Debt leveraging can put more control into the hands of business managers through capital restructuring

*New facilities, equipment and/or products can lead to increased efficiency and higher sales. The lower costs and higher revenue may translate into higher retained earnings.

*Tax Benefits: Debt costs may have tax benefits that reduce the cost of debt. For example, if the cost of debt lowers a businesses tax bracket by 19% for a corporation that would otherwise make between $75,000-$100,000 for a given tax year i.e. the tax bracket changes from 34% to 15% the savings on $74,000 of revenue would be approximately $14,060 excluding nominal base tax dollar amounts.

*Asset retention: Debt can also enable a business to retain assets that may be needed for other areas of business operation that would otherwise cost more to run. For example, if a line of credit charges 9% but a fixed asset loan costs 6% the latter debt is more cost effective.

TIPS TO CONSIDER WHEN USING DEBT LEVERAGING:

*Research: Knowing what the debt will finance and if such financing is likely to prove profitable is an important aspect of the debt decision.

*Ratios: Ratios such as the current ratio i.e. assets/liabilities, debt to asset ratio, and the debt/equity ratio can be used to determine if the level of debt taken on is risky. Generally a current ratio between 1-2, and debt/asset below 50% are considered acceptable for businesses, but these numbers are relative to some extent.

*Interest Rates: The cost of debt can change depending on the interest rates. Since interest rates change, choosing not to take on debt at certain times may be beneficial.

*Economic Cycle: If an economy is heading into a recession, sales may decline or not increase. The benefits of taking on debt for business expansion during these times may require more strategic thinking.

*Sales Forecasts and Market Research: Having an idea how the market will react to debt leveraged expansion or projects can be key in the decision to take on debt.

To recap, debt can be used to finance opportunity, business revenue growth, capital investments, tax savings and other forms of financial activity that may prove profitable. Taking on debt does open the opportunity for increased wealth but only under certain circumstances and environments. The information in this article outlines some of key aspects of debt value, consequences and uses. Knowing how much debt to take on, if it is the right time to take on debt and the affects of debt on profitability are all useful considerations to take into account when deciding to take on debt.

Sources:

http://yahoo.brand.edgar-online.com/fetchFilingFr ameset.aspx?dcn=0001193125-08-041768&Type=HTML
http://www.iht.com/articles/2008/02/26/business/rt rcol27.php
http://www.buffettsecrets.com/warren-buffett-debt. htm
http://www.taxgaga.com/pages/c-business/taxrate.ht ml
http://www.cato.org/pubs/pas/PA120.HTM

by A.W. Berry