When it’s time to ignore Shakespeare on borrowing
Whiel there is a risk attached, debt can often be the sensible route to financing growth. Picture: iStock.
The advice of Polonius to Laertes to “neither a borrower nor a lender be” was made without corporate finance in mind. It wasn’t exactly Shakespeare’s speciality.
Borrowing, in and of itself, is neither good nor bad. Debt can often be the sensible route to financing growth, so long as there’s a clear return to be made in the long run. Yet it’s far more dangerous when it is leaned on to keep the lights on for a struggling business.
A smart business needs to not only know when to borrow but what kind of borrowing best suits its needs.
“Debt works best when there is a clear plan for how the money will be used,” says Enda Grenham, head of debt advisory at Goodbody. “The additional return it should generate and how the business will repay it without becoming overburdened.”
There are identifiable commercial reasons to borrow when it comes to increasing production capacity or making an acquisition. Whatever the reason to borrow, the debt should result in increased cash flow that ensures it pays for itself.
“Borrowing makes sense when it funds growth that generates returns exceeding the cost of debt,” says Darren Brennan, debt advisory in corporate finance at PwC Ireland.
That provides businesses with a simple test before borrowing; is the expected return greater than the cost and risk of financing it?
It also means that it’s easy enough to spot when borrowing is a warning sign for greater issues within a business.
“If borrowing is being used to solve a recurring cash flow issue rather than fund a specific business objective, this is a cause for concern,” says Mark O’Rourke, managing director of Bibby Financial Services.
There’s a huge difference between a rough patch and real structural weaknesses. Borrowing can cover up issues in the short term but, with deeper issues, it will only make the problems worse.
“If the borrowing rationale is that the business cannot meet its existing obligations, the conversation should be about restructuring, not new debt,” says Brennan.
That’s why debt should really only be considered when it is to finance an opportunity rather than to kick a problem down the road. Even then, it’s worth noting that not all debt is the same.
“The challenge is not simply access to finance but understanding which type of finance is best suited to the requirement and how different funding solutions can work together,” says O’Rourke.
The options can range from traditional bank lending through to revolving facilities and overdrafts, invoice financing, asset-based lending, or even state-backed funding.
“The right mix will depend on the company’s cash flows, objectives and future plans,” says Grenham.
It’s also critical that a business, even one in good stead at present, doesn’t overplay its hand when it comes to debt. Borrowing really should be within the means of the organisation.
“An experienced adviser will model debt capacity conservatively, ensuring the business retains headroom for unexpected events rather than borrowing to its theoretical limit,” says Brennan.
Debt capacity really comes down to cash flow rather than future projections. Lenders want to know what will happen if things get tight for a business and if it can still be counted on to make repayments. The goal is to ensure there’s an ample cushion should anything go south.
“The objective should not be to maximise the amount of leverage available, but to establish a sustainable level of debt that preserves operational and financial flexibility,” says O’Rourke.
While patience is usually advisable, an excess of it can prove costly. “One of the most common mistakes is leaving financing too late,” says Grenham.
Getting an early start when it comes to borrowing provides more choices for businesses and enables them to start from a stronger negotiating position. It also provides time to examine the best course of action because the cheapest option isn’t always the best one.
Things didn’t end all that well for Polonius in Hamlet, or Laertes for that matter, or, indeed Hamlet. The Bard probably isn’t the most inspiring source when it comes to financial advice.
Instead of a “do not borrow” approach, it should be to borrow for the right reason, in the right way, at the right time.
