Every company’s goal is to maximize value in all areas of the firm. Opportunities and costs are weighed to determine is this going to add value and if so, how much? Value can be hard to determine and quantify, so let’s look at it in terms of financing decisions. The main objective in terms of financing value in a firm’s structure is to achieve the optimal combination of debt and equity.
Using debt includes both pros and cons. The pros include tax benefits, encouraging view in the market in terms of future results, and reducing agency cost. However, using debt can prevent you from taking additional projects and jobs due to lack of finances, which can create financial uncertainty within the firm.
These cons can be mitigated by creating strategic and comprehensive business plans and strategies. While you are planning for the future of the firm, analyze what type of cash requirements you will need in the future to set a suitable level of indebtedness. With today’s technology, if you don’t have past budgets to work off of and are unsure of where to start, use industry averages and examples in your business environment to determine an appropriate amount of cash needs. This can assist in decreasing the probability of financial distress and uncertainty in the future of your company.
No two companies can rely on the same mix of debt and equity. For example, if you look at companies that have high volatility of cash flow, you would want less debt to capital because the tax benefit from using more debt doesn’t outweigh the risk of bankruptcy. However, if a company typically has lower operating margins and high fixed costs, they would want a higher ratio of debt to capital since they don’t have as high of a risk of financial uncertainty. On the highest end of the spectrum are companies with high operating margins and strong cash certainty with low variability. These companies want more debt to capital because they can borrow at a lower cost for longer.
All these factors can become overwhelming, so we suggest you take a step back and evaluate the following factors within your company:
Future investment opportunities
Strategic business plan
Tax plans
Market fluctuation
Variables within P&L and balance sheet that influence cash flow
Financial uncertainty costs
Cash requirements
In the end, the greatest way to generate value is to make sound financial decisions, which begins with looking at the way you structure your company. Each time you analyze these different factors within your company, you will be closer to achieving your goal in driving value.