Why do most companies have debt and are there any companies without debt?

Question

Somewhat inspired by this question. It seems that no matter what company I hear about, they always have some sort of debt to someone. Even if the company is in great financial shape and makes tons of profit for their shareholders, they still seem to owe other companies money. So, this makes me wonder - why is it so? Isn't debt a Very Bad Thing™? Wouldn't it be beneficial for everyone (companies and private people) if there was no debt? I can understand borrowing money when you're in a tight spot; or when you want to start a new business and need the initial funding to get off the ground - but why keep on taking more debt when you could just pay immediately and in full? Isn't that just asking for more unnecessary problems? Why is this so common? What am I missing here?

Answer 1

Debt is not always bad, no. Debt allows companies to expand or provide services in a way it could not usually even if they are healthy. Consider a mortgage. Most people are unable to come up with the cash to buy a house outright yet are quite capable of servicing a loan, allowing them to "own" the house far in advance of having the cash. Same with businesses. Debt also can be used to smooth cash flow, keeping staff paid and consumables purchased during a program of work that is due to be paid upon completion. Paying in full essentially commits all your resources to that thing. Holding debt allows you to continue to do more because you can use your cash to do other things while the main work is debt funded, backed up with the payment for that program.

TLDR: There are lots of reasons to hold debt, not all bad.

Answer 2

In a word, leverage.

If you have $100 an can make a 10% return on it through the operations of your business you have the ability to bring in $10. If you BORROW $1M dollars and it costs you 8% in interest, then you can profit $20,000 ($100,000-$80,000). Earning a profit off someone else's cash is not a bad way to make a living.

I do this myself in that I have a 30yr mortgage on a rental house I own, that I could pay off in cash today. However, I prefer to finance it so I can earn on the bank's money and invest my cash in other ventures that will net way more than the ~4% interest I am paying on the note.

Another reason for shorter term loans is just to even out cash flow for companies that extend credit or are working on projects with a longer term return on investment. If you are giving net 30 terms and you have a lot of operating expenses you need to pay your bills until your customer pays you.

Answer 3

In short - debt is cheaper than equity, as long as you don't take on so much debt that you risk bankruptcy. This comparison is called 'the Cost of Capital' in corporate finance.

Cost of Capital refers to how much it costs a company to maintain the actual funding that allows it to exist. If a company is funded solely by debt with an interest rate of 4% / year, then its cost of capital is 4%. But shareholders have more risk than debtholders [because if a company goes bankrupt, the debtholders get paid back first, and then shareholders get whatever scraps are left]. So a prudent shareholder would 'require' returns to be more like 10% [in the form of dividends + capital appreciation on the value of their shares].

So if a company is funded 50% by debt and 50% by equity, its cost of capital would be 7%. If a company's activities earned it 8% per year, and it was funded 100% equity, it wouldn't earn back the 'cost of capital' required [also called the 'required rate of return] of 10% - this implies that the shareholder's financial risk isn't properly compensated by the return of the company. In such a case, a shareholder would be better off selling their shares and buying something with a more adequate risk compensation. But if it is funded 50% by debt, and its cost of capital is 7%, then an 8% return on its own activities would be great.

So why don't companies fund themselves 100% by debt, which is cheaper than equity? First of all, there is no such thing as a company with '0%' equity financing, because someone needs to own the company. But let's say a company wanted to be funded 99% by debt. Doing so would greatly increase its 'insolvency risk' - ie: the risk that it goes bankrupt. Remember - debt is cheaper than equity, because debt holders have legal rights to payments. That means that if you take on more debt than you can afford, you may go bankrupt.

The same principles can apply to individuals, if you are taking debt on for an investment. This is called 'financial leveraging'. Meaning if I have $100 and invest in a diversified index fund that grows 7% / year, I will have $107 in 12 months - but if I have $100, and also take on a $100 personal loan with a 5% interest rate, then in 12 months I will have ($200 * 1.07 - $5) = $209 in investments, and after paying off my $100 loan, I would be left with $109 after interest. This means with this amount of leveraging I can achieve 9% annual growth on my savings instead of 7%. However for many people, determining whether you have 'too much' debt is quite difficult, so the less-risky option of minimizing debt is often promoted, to be conservative. The risk is that in a year where the market drops by 20%, if you have to pay off your personal loan, you will end up with ($200 *0.80 -5$) = $155, and only $55 after paying off your loan. This shows that with leveraging, your gains are magnified, but your losses are magnified, too. So there is very serious risk involved.

Answer 4

Fundamentally, people can walk away from a company.

The thing to realize here is that decisions are made by people. Financing with debt lets you run hotter, and if you know what you're doing with debt management, and have a way to consistently get your capital to produce at higher percentages than the debt is costing you, it can absolutely let you make more money faster... but it also means that if everything starts going bad, it can get really ugly, really fast. Companies, unlike most individuals, can hire skilled professionals to do their debt management for them. Companies are also more often able to pull better-than-interest return on their capital. Among other things, when individuals take on debt, it's usually for reasons other than maximizing income.

The critically important thing, though, is that the company is the one with the debt. If it craters, then everyone's out... about as much as they put in, and no more. If your personal debt craters, then you personally are on the hook in a way that it will take years to crawl out from under, even if you declare bankruptcy, and you'll lose a great many assets that may well matter to you personally. If your company crashes out from under you, the damage to you personally is generally much less. It's however much you had invested in the stock, and/or maybe needing to find a new job. Thus, it behooves (most) individuals to be a great deal more risk-averse in such things than companies... and taking on debt pretty much always means being higher-risk.

Now, there are companies out there that avoid debt. They are generally companies run by people who are themselves either strongly debt-averse or strongly risk-averse for various reasons. When it comes to surviving downturns gracefully (like, say, reducing the costs of churn), there are some real advantages there. That's not most of them, though, and I suspect that it's basically none of the really large ones. Being risk-averse can help you survive longer, but it absolutely limits the ability to rapidly grow.