Capital Structure: Equity Versus Debt

DISCLOSURE: THIS POST MAY CONTAIN AFFILIATE LINKS, MEANING I GET A COMMISSION IF YOU DECIDE TO MAKE A PURCHASE THROUGH MY LINKS, AT NO COST TO YOU. PLEASE READ MY DISCLOSURE FOR MORE INFO.

Capital Structure: Equity vs Debt

Two primary ways a company can fund growth

INTRO

Two types of companies exist - those that create value, and those that destroy it. Usually, that happens right before your very eyes, and often without you even realizing it.

Have you ever bought stock in a company and almost instantly lost money? I might know a very good reason why. The factors behind their growth weren't carefully considered in enough detail. Nowadays, there tends to be so much focus on growth without sufficient consideration for fundamentals.

First of all, we won't even consider a company's stock for investment unless it is at least profitable. From there, an analysis of its balance sheet, along with management's use of the company's earnings, is key. How much long-term debt do they hold? How much capital stemming from equity versus debt makes up their capital structure? Should management reinvest earnings into the business or return money to shareholders (i.e., payout dividends or repurchase shares)?

The most important management initiative centers around the allocation of the company's capital. Allocation of capital, over the long-term, will certainly drive the determination of shareholder value.

Let me tell you how to avoid buying “empty” companies.

Organic Growth Wins

Where to allocate capital is linked to a company's life cycle. As a company moves through its life cycle, its sales, earnings, cash flows, and growth rates will change pretty significantly.

A company is typically unprofitable in the development stage. Its focus at that time is developing products, penetrating markets, and establishing a customer base.

During the rapid growth stage, a company may be profitable but growing so fast that it needs to configure how to best support that growth. Oftentimes, retaining earnings is not sufficient, so it may have to turn to borrowing money (assuming long-term debt) or issuing equity to finance the growth.

In the 3rd stage of maturity, growth slows and the company begins to generate excess cash flows, more than is needed for development and operating costs. The last stage of decline is marked by declining sales and profit, but it is still generating excess cash flows.

Let's go further with a practical example. Imagine you own a lemonade stand. Business is booming, and you're making good profits from your juice sales. You might feel content with the way things are progressing. You're adding value and reaping the rewards.

As your profits accumulate, you decide to expand by opening a second stand, then a third, and so on.

The growth is steady, you have no debts, and you remain the sole owner. However, it takes you a decade to transform into a large company.

But what if you want to accelerate this process? There are two ways:

          A: Borrow money for expansion.

          B: Sell a portion of your business for expansion.

Let me explain the first option first.

Funding Through Debt

If you borrowed money in the first year, you could open three new lemonade stands simultaneously, potentially tripling your profits.

This is a strategy many businesses employ: borrowing funds to fuel expansion. Sometimes, it's a success; other times, it's not. However, if you borrowed money for your lemonade stands and two of them failed, you'd face a dilemma.

You'd still be obligated to repay the borrowed funds, but with only one stand having proved successful, the level of profits you were projecting will be much lower. If you can't meet the repayments, the bank could seize your assets and liquidate them to cover the debt.

So while this strategy is great for expansion, it comes with risk - the risk of the entire lemonade operation going bankrupt. Debt is dangerous.

A good indication that a company has a durable competitive advantage (the type in which we are actively trying to identify and invest in) is that it will be relatively free of long-term debt. Typically, such companies will instead spin off a lot of cash (high levels of free cash flow FCF), leaving it with little or no need for debt.

Hence, the financial world devised an alternative approach to fund growth outside of borrowing.

Funding Through Equity

To open three lemonade stands simultaneously, you could also bring in a partner. But nobody ever does anything for free. So, the partner requests you split the ownership, and you’re now a 50% owner (or some other proportion, depending on what's agreed upon) and are therefore entitled to only 50% of the profits.

You basically gave up a portion of future profits to fuel expansion. If the business is in trouble, your partner will be far more compassionate when compared to banks. And if the business goes under, you and your partner both lose money, so it’s a win-win or lose-lose situation.

That’s why so many companies prefer equity financing. In the first place, equity financing may be less risky than debt financing because you don’t have a loan to repay or collateral at stake. Debt also requires regular repayments, which can hurt your company’s cash flow and its ability to grow.

That being said, you do give up a part of your business when funding growth through equity. f you eventually give up more than 50% of ownership, you can lose complete control of your company. To regain it, you’d likely have to buy out investors — which may get expensive.

Debt Or Equity?

So, which strategy is better to fund growth: debt or equity? Let's take a look at this picture.

If you observe closely, you'll notice I included two example companies. What's striking?

Carvana, which is utilizing equity funding is younger and smaller. How come? Because they can't afford the interest payments associated with debt financing. But there's a significant risk here for existing shareholders. They face dilution with each equity issuance, destroying value.

Share dilution occurs when a company issues more stock, reducing the ownership percentage of current shareholders. For instance, if a company issues 100 shares to 100 shareholders, each with 1% ownership, and then issues another 100 shares, each shareholder's ownership drops to 0.5%. On the flip side, big companies (like McDonald’s) often opt for debt financing. They'd rather pay interest than relinquish control. However, this debt does impact their financial health and stability.

Read more about the pros and cons of equity vs debt in this informative article by The Hartford: Advantages vs. Disadvantages of Equity Financing.

Conclusion

Neither strategy is flawless. Both options provide cash for your business, but each has pros and cons. The best test of a company's financial power is its ability to service and pay off any long-term debt found on its balance sheet by way of its earnings. We also speak in more detail within this prior article: The Key to Sustainable Growth.

Companies with a sustainable competitive advantage will generate strong enough earnings that they can easily pay off their long-term debit within just a few years. Looks for companies with long-term debt burdens of fewer than five times current net earnings.

Personally, I prefer companies that grow organically. They don't issue new shares or accumulate significant debt, and they're not "buying" growth via acquisitions. Investing in these will produce the highest return.

To level up your investing game, feel free to join the world’s most powerful stock market newsletter for wealth, stability, and happiness.

For more robust and meaningful Investing insight & analysis, consider subscribing to RIIQ Pro, our premium newsletter:

• A company-specific Deep-Dive Analysis (provided weekly)

• A detailed write-up of a RIIQ Key Investing Insight (provided weekly)

• RIIQ Top 10 Watchlist - a list of the top 10 companies being monitored and evaluated heavily due to varying factors, along with details of why they may be in our top 10 (provided monthly)

• Bonus: A FREE download of Legendary Investor Insights. 10 pieces of practical wisdom from legendary investors like Warren Buffett, Peter Lynch, Charlie Munger, and many more.

Subscribe for FREE to the Raising InvestorIQ YouTube Channel for more leading Investing info, insight, and analysis.

Do you want to invest on your own (but don’t know where to start)? Tykr gives beginners the power to manage their own investments with confidence.

14-Day FREE trial when you sign-up!!

Disclosure/Disclaimer

As a Tykr affiliate, Raising InvestorIQ earns from qualifying purchases. As a Seeking Alpha affiliate, Raising InvestorIQ earns from qualifying purchases.

Information provided on this site is based on my own personal experience, research, and analysis, and it is not to be construed as professional advice. Please conduct your own research before making any investment decisions.  I am not a professional financial advisor, stockbroker, or planner, nor am I a CPA or a CFP.

The contents of this site and the resources provided are for informational and entertainment purposes only and do not constitute financial, accounting, or legal advice. The author is not liable for any losses or damages related to actions or failure to act related to the content on this website.