Debt versus Equity
In my previous Blogs I have talked about Equity and Gearing and Leverage as two important things you need to understand when making investment decisions. The third thing you should know is the difference between debt and equity and how this might affect the financing of your investment decisions.
The key ratio you must understand is:
Assets = Liabilities plus Equity (A = L + E)
In any investment decision, whether it is to buy a house, rental property, equity investments or a business, you will need to make a decision on how to fund this purchase. You can use debt (loans) or your own equity (cash) or a combination of the two. The relationship between how much debt and equity you have is called your gearing.
The key things you should consider in determining the split of debt and equity are:
1. What is the cost difference?
If you use your cash, what was the return on that cash prior to it being used?
Have you sold another asset to obtain the cash? If so, what was the return on that asset? Referred to as opportunity cost.
At the moment the cost of debt is very low - how does this compare to the returns above?
2. Are there any Tax Implications?
Are you able to obtain a tax deduction on any interest paid on the debt?
Key question here is whether there is any income produced by the acquired asset.
3. How Good is your Cash Flow Management?
With debt, you have to pay interest and principal (unless interest only), so your cash flow has to be able to support this. With equity there is less drain on your cash flow as there are no repayment obligations - there may be a higher opportunity cost in using your equity.
You must prepare a cash flow forecast every time you take on any debt. This will help you work out how much headroom you have and see what options you have in certain circumstances such as increased interest rates, loss of income, loss of tenants or illness.
One positive thing about debt is that it is a compulsory form of saving. Each month the bank automatically takes the money out of your bank account to pay off your loan. As a result it is not in your account for you to spend!. Everyone “wastes” money and it is amazing how you can adjust to the reduced cash flow and very quickly you will have built up your equity be reducing your debt.
4. Asset Security and Risk
If you borrow money then you will have to provide security to the lender over the asset purchased and maybe additional assets. You may also have to provide guarantees. Are you comfortable with this and the risk associated with this?
If you use your own equity there would be no asset security issues.
Summary
I have always lived by the motto “a good business person is always in debt”. If you want to grow your asset base you cannot do this solely by using your own equity. You must:
Use a combination of debt and equity
Prepare a cash flow forecast and budget to help determine this split.
Review, review and review this - the day after you prepare it, the assumptions will need updating.
Determine your appetite for risk - will you sleep at night with that much debt?
Work out the opportunity cost of your equity.
Get advice on the tax options of the investment.
James
Image source https://www.growthbusiness.co.uk/debt-vs-equity-best-2551327/