Canada: Debt is NOT a 4-Letter Word

Last Updated: September 17 2015
Practice Guide by Duff & Phelps

There tend to be two types of business owners and executives: (1) those who love debt, and who use the maximum amount of leverage possible; and (2) those who avoid debt like the plague. While an appropriate amount of leverage is highly dependent on the fact-specific circumstances of any given business, in many cases, a modest amount of debt is the best solution.

Debt, or financial leverage, allows business owners and executives to increase shareholder value, so long as the risk is manageable. This is because debt can be used as a low-cost substitute for equity financing, and because interest payments are (usually) tax deductible.

Consider the following example. Company A currently generates $1 million in earnings before interest and taxes (EBIT) and has no debt. It pays taxes at a rate of 35%, leaving $650,000 of earnings after-tax. If Company A’s equity is $5 million (consisting of share capital and retained earnings), then the after-tax return on equity under a debt-free capital structure is 13% (calculated as $650,000 / $5 million).

Now assume that Company A borrows $2 million at a 7% interest rate, and pays a $2 million dividend to its shareholders (note that this can be a tax-deferred dividend if the recipient is a holding company). The interest on the debt reduces Company A’s income by $140,000, but income taxes are also reduced, resulting in revised after-tax earnings of $559,000. However, Company A’s shareholder’s equity has declined to $3 million, given that $2 million in retained earnings have been paid out in the form of a dividend. Consequently, the after-tax return on equity increases to 18.6% (see Exhibit 1).

Exhibit 1
Comparison of Shareholder Returns For Company A

Another benefit of replacing equity with debt is added diversification for shareholders. This is because many business owners have most of their personal wealth invested in their business. By replacing equity with a modest amount of debt, the owners can invest the proceeds in a more diversified portfolio.

While a recapitalization of the business may offer attractive returns, business owners and executives should carefully consider the risks involved. The introduction of debt into a business creates ‘financial risk’, because the lender has a priority claim on the assets of a business. It will also result in banking covenants, which may constrain the activities of the business. Common banking covenants include minimum working capital levels and banking approval prior to making any major capital expenditures or shareholder distributions.

This begs the question “how much debt should my company use?” The answer is “it depends”. While not an exhaustive list, some of the factors that should be considered when determining the appropriate amount of debt for a company include the following:

  • cash flow levels and the volatility thereof. Cash is required in order to fund both the interest expense and principal repayments. To the extent that cash is required to service debt, it is not available to the company for other uses, such as capital expenditures. Businesses that are cyclical, or that have volatile cash flows, normally employ less debt than those with stable cash flows;
  • the quantity and quality of underlying assets. Most lenders look for security against their debt. Traditional lending formulas include:
      Up to 75% of accounts receivable under 90 days;
      Up to 50% of inventories, depending on their nature and salability;
      Up to 60% of the appraised value of capital assets, depending on their nature; and
      Up to 75% of the appraised value of real property;
  • the after-tax cost of debt. This is a function of the stated interest rate that will be charged and the effective tax rate at which interest will be deductible. In addition, consideration should be given to any fees and charges that will be incurred to place or sustain the debt;
  • banking covenants, including financial performance measures (such as minimum levels of working capital, equity and cash flow) and restrictions on business activity. Both covenants on existing lending arrangements as well as covenants on new debt arrangements should be considered;
  • industry norms. While no two companies within a given industry are exactly alike, the use of debt among companies within an industry in general provides some indication as to the degree that lenders are interested in extending debt financing within that industry;
  • the stage of the company’s life cycle. Early stage companies tend to use less debt as compared to mature companies, as early stage companies require cash in order to finance growth and expansion; and
  • the personal preferences of the business owner(s) and executives. Ultimately, those who own and operate the business must be satisfied with the risk-reward tradeoff of their company’s capital structure.

Exhibit 2
Factors that Influence the Amount of Debt

In most cases, it is prudent not to employ the maximum amount of debt that can be raised within a business. Rather, business owners and executives should leave themselves some degree of flexibility in the event that unexpected issues and opportunities arise. Leaving some “wiggle room” is also advisable from the standpoint that a bank’s appetite for lending and the terms and conditions thereof tend to evolve over time. Witness the high levels of debt usage during the 2005-2007 time period, inspired by relaxed banking covenants and low interest rates. Circumstances have changed in 2008, as bankers have returned to more conservative lending approaches. Business owners and executives should avoid being in a position of having to manage the bank rather than managing their business.

Finally, there is the issue of whether short term debt or long term debt should be raised. As a general rule, businesses normally follow the “matching principle” in this regard. That is, matching the term of the debt with the term of the underlying assets used to secure that debt. Therefore, short term debt (such as bank operating loans) should be used against short term assets (such as accounts receivable and inventories) while long term debt (such as capital leases and mortgages) should be used against capital equipment and real property.

To summarize, the use of some debt in a business can serve to increase shareholder returns and allow business owners to diversify their investments. However, caution must be employed to ensure that the financial risks are fully understood and manageable. Business owners and executives should consider factors such as cash flow levels, underlying assets, the after-tax cost of debt, banking covenants, industry norms, company life cycle and personal preferences when determining the level of debt that is appropriate for their business.

This document is not intended to create an attorney-client relationship. You should not act or rely on any information in this document without first seeking legal advice. This material is intended for general information purposes only and does not constitute legal advice. If you have any specific questions on any legal matter, you should consult a professional legal services provider.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Contact the Author?
Click here to email the Author
In Association with
In Partnership with
Other Canada Advice Centres
Competition and Antitrust
Mergers and Acquisitions
Labour and Employment
More Advice Centers
Useful Resources
CBVs are experts in their field. The following articles and papers have been written by CBVs, several articles have been featured in various national publications.
Tools
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Check to state you have read and
agree to our Terms and Conditions

Terms & Conditions and Privacy Statement

Mondaq.com (the Website) is owned and managed by Mondaq Ltd and as a user you are granted a non-exclusive, revocable license to access the Website under its terms and conditions of use. Your use of the Website constitutes your agreement to the following terms and conditions of use. Mondaq Ltd may terminate your use of the Website if you are in breach of these terms and conditions or if Mondaq Ltd decides to terminate your license of use for whatever reason.

Use of www.mondaq.com

You may use the Website but are required to register as a user if you wish to read the full text of the content and articles available (the Content). You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these terms & conditions or with the prior written consent of Mondaq Ltd. You may not use electronic or other means to extract details or information about Mondaq.com’s content, users or contributors in order to offer them any services or products which compete directly or indirectly with Mondaq Ltd’s services and products.

Disclaimer

Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use or performance of information available from this server.

The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.

Registration

Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.

Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

If you do not want us to provide your name and email address you may opt out by clicking here .

If you do not wish to receive any future announcements of products and services offered by Mondaq by clicking here .

Information Collection and Use

We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) – meaning more free content for registered users.

We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to unsubscribe@mondaq.com with “no disclosure” in the subject heading

Mondaq News Alerts

In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.

Cookies

A cookie is a small text file written to a user’s hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

Log Files

We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.

Links

This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

Surveys & Contests

From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.

Mail-A-Friend

If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.

Security

This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to webmaster@mondaq.com.

Correcting/Updating Personal Information

If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to EditorialAdvisor@mondaq.com.

Notification of Changes

If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

How to contact Mondaq

You can contact us with comments or queries at enquiries@mondaq.com.

If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at problems@mondaq.com and we will use commercially reasonable efforts to determine and correct the problem promptly.