- A company's free cash flow (FCF) shows the cash it generates after taking into account cash outflows needed to support operations and maintain capital assets
- Contrary to popular belief, debts are not necessarily bad for a business
- Debt can help a business make up for insufficient cash flow
Harare-In the instance of Zimbabwe, some businesses have previously reported successful outcomes and strong financials despite the country having a sizable amount of debt. For instance, Delta Corporation is profitable regardless of how much debt it has. Due to these situations, the entire subject of borrowings as a source of worry needs to be reassessed. In this article, debt will be seen as advantageous because it can increase a company's value in comparison to businesses that avoid debt.
According to the graph above, Econet and Simbisa each owe more than ZWL $1 billion in debt, which would typically send management into a tailspin. The dynamics have shifted, though, and organizations can now thrive and expand even with high levels of borrowing. We'll look at why debt isn't a concern for businesses in this piece.
This article will show when borrowing money might be a practical alternative for a business. Maintaining a steady cash flow is one of the most challenging problems that small businesses face. Although many small firms are profitable, their monthly or quarterly earnings are rarely sufficient to support growth. Your company may access the funds it needs to keep a healthy level of cash flow and pay bills when they become due with the help of an affordable line of credit.
When evaluating a company for investment, one of the most crucial aspects to take into account is its debt level. The degree of debt in the economy and among businesses is assumed to be reflected in foreign investments on a microeconomic level. Investing in a company that has a lot of debt is preferable to doing the opposite. Since it would be able to manage its finances primarily from internally generated funds and with no external obligations, a corporation with no debt would be preferable in an ideal world. Contrarily, debt is not always a bad thing, as shown by the fact that some businesses are successful even if they have high debt levels.
Businesses in Zimbabwe raise debt through a combination of debt financing (borrowing money as loans from banks or other lending institutions or simply purchasing debt securities such as bonds, notes, and corporation papers) and equity financing (ZSE and VFEX). If a firm accepts a loan, it is legally required to repay it following the terms set forth by the lenders and lender. Debt-free businesses should think about borrowing money since it will enable them to put that money into growing their business. The problem arises, though, when a company that already has a lot of debt on its balance sheet wants to add more.
As the company is required by law to pay its obligations first and shareholders are always last in line to receive earnings, this increase in debt may negatively affect shareholders. Debts are not considered terrible indicators for a firm, despite several metrics, like declining profit margins or persistently negative operating cash flow, being viewed as such. A company's debt isn't always a bad thing. If a corporation decides to take on new debt to fund a project that could double or triple revenue, this debt may end up being more valuable to investors and advantageous to the company in the long run.
The free cash flow (FCF) of the company can be used to determine whether or not the company can repay its debt. As a general rule, if a company's long-term debt is less than three times its average FCF, it will be able to repay its debt using free cash flow within three years. Consistently negative free cash flow combined with rising debt levels, on the other hand, can be a red flag for investors.
(A company's free cash flow (FCF) shows the cash it generates after taking into account cash outflows needed to support operations and maintain capital assets. Free cash flow, as opposed to earnings or net income, is a metric of profitability that takes out non-cash items from the income statement and accounts for spending on assets and equipment as well as changes in working capital.) To finance a business expansion, management may decide to either raise money from investors (equity funding) or borrow money from banks (debt financing). On the other hand, debt is a viable source of capital because it is less expensive than equity financing and does not dilute ownership.
Debt can help a business make up for insufficient cash flow, which is another incentive to consider it. The relationship between cash flow and business debt can be complicated. Any period of negative operating cash flow, in general, will increase a company's reliance on debt. A good debt represents a wise investment in the financial future of your business. It has long-term positive effects on the business while having no adverse effects on your overall financial status. There should be a clear justification for the debt's acquisition as well as a workable repayment strategy.
Taking Advantage of Debt
For two reasons, a firm should use debt to finance a sizable portion of its operations. First, by allowing them to deduct interest from corporate income taxes, the government encourages companies to use debt. Additionally, debt is a much more affordable choice than equity. The first stage is the reality that equity carries more risk than debt.
Common shareholders frequently have no legal requirement to receive dividends, so they anticipate a specific rate of return. It is significantly less risky for the investor because the corporation is required by law to pay the loan. Also, shareholders—those who paid for equity—are the first to lose their interests when a corporation declares bankruptcy. Finally, a significant amount of return on equity comes from stock appreciation, which calls for increasing sales, profits, and cash flows.
Owing to these risks, an investor typically seeks a return of at least 10%, while debt is frequently available at a lower rate. Funding for a public corporation shouldn't come exclusively from stock. It has no effect. Because debt has lower costs than equity, equity investors can use it to leverage their capital and increase returns.
Closing Thoughts
Contrary to popular belief, debts are not necessarily bad for a business and help it grow more quickly. Debts are also a more economical and effective approach to finance a firm when it needs money to expand. Only when management fails to keep good debt control if there is a problem. A business must balance the use of debt and equity to maintain a low average cost of capital.
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