Out of WACC

A previous suggestion that an increase in interest rates may cause businesses to suffer in their value, alongside with their cash flows and the well being of their customers caused a number of subscribers to contact me with comments.

  • “I remember those days in the late 90’s”
  • “I will never have an overdraft again”
  • “I currently have enough debt to start a small 1st world country”

Just a warning, of course.

Good times

When times are good and businesses are performing they end up with profits after taxes have been paid. Some of that will be paid out to shareholders; some of it will be retained in a business “for a rainy day”, to help the business to grow, or to simply avoid paying out taxes on dividends.

So the question at the end of the year comes down to “How much do we need to keep in the business? Let’s take out the rest and have a good time – we’ve certainly worked for it.” An alternative view is that it is good for business owners to spread their risk and invest some of their money in other asset classes.

Bad times

In tougher times businesses very often run out of money, and have a miserable time of it as a result. When that happens shareholders often rue the times when they removed their money to “have a good time”. It is very difficult to be in a place where salaries are paid late, rents go unpaid, suppliers are calling for payment and the lights might be turned off any day now. With no cash reserves they try to borrow money with a weak balance sheet. That is almost impossible, and if they do get it right, it is at inflated interest rates, which then climb higher with the bad times.

Of course bad times also mean higher risk, and sometimes the business owners want to get their money out of the business to ring fence it from the coming storm.

Somehow in all that we see the true value in a business. The owners don’t have confidence in the thing, so they take their money out. Banks won’t lend to it because they see a high risk. There is an inability to pay creditors. Sales are down. Margins are falling. You see the problem with the business value in such circumstances?

These times are coming for many businesses.

The balance

What do you do about it? What is the optimal amount of debt to have in a business? How much cash should be left in the business to tide it over these poor times?

  1. Borrowing money from a lending institution costs interest which is subject to increasing as the economic outlook deteriorates. Those interest payments are tax deductible.
  2. Borrowing from shareholders is often free, and as long as the business is solvent, the loans are easily repayable.
  3. Cash in the business bank account by way of previous profits left in the enterprise is top prize.

At what stage do we limit the borrowings of a business? How much cash should be left in the enterprise? How much can we pay to the owners, either as salary or as dividends?
Getting the balance right is relatively simple if all the facts are at hand. You accountant should be able to help you.

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