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This is a bit obvious but just want some confirmation. What is riskier in a company: High debt and low equity or low debt and high equity? Why?

Rafael Martínez
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    Risk from who's point of view, the company or the owner(s)? – quid Jan 03 '17 at 18:27
  • As an investor. Assuming you're choosing a stock to invest in. (I guess that would be an owner POV since you're buying a piece of the company) @quid – Rafael Martínez Jan 03 '17 at 18:39
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    You would base it on comparable companies. Each industry has different leverage ratios. – Ross Jan 03 '17 at 18:43
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    Higher debt relative to equity is always higher risk but with higher potential return on equity. There is an optimal level depending on growth rate, cyclical business, and many other factors. – doug Jan 04 '17 at 08:03
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    I don't see the reason for the vote to close; question is relevant to an individual investor's understanding of corporate financing. It is not about economics, and it is fairly objective. – Grade 'Eh' Bacon Jan 04 '17 at 14:23

2 Answers2

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Instead of thinking about a company and debt, simplify things and consider a single rental property:

Assume you have $100k in cash, and want to invest in some real estate. If the property costs $100,000, you could either pay $100,000 of your own cash, or you could pay $50,000 of your own cash and take on a $50,000 mortgage [other mixes are obviously possible]. Assume the mortgage is at 3% annually, for 25 years, which makes a ~$240/month mortgage payment (~$3,000 annually), of which $125 is interest ($1,500 annually) at the start of the mortgage. If the property earns $5,000 / year after all pre-mortgage expenses, consider both scenarios:

(1) If you bought in cash, you would have earned $5,000 on a $100,000 investment, meaning 5% profit per year.

(2) If you bought in half cash with a 50k mortgage, you would have earned $5,000, but would have had to pay $3,000 in mortgage payments. So your net cash flow would have been only $2,000. Now, even though your net cash flow [all cash received less all cash paid] is $2,000, some of that cash [about 1/2 of the mortgage payments] paid off the principle of the mortgage. This means that you will ultimately receive the benefit of that payment later, because there is less debt owing on the property, and eventually the mortgage will be paid off. Technically, this means you have net income for the period of about $3,500. $3,500 / a $50k cash investment = 7% profit per year.

(1) If you bought 2 identical properties, and instead of buying 1 of them with $50k cash and $50k mortgage, you buy both, with total cash cost of $100k and total mortgage of $100k. This leaves you with $10k pre-mortgage net rental income, and $4k of net cash flow after mortgage payments. Your total net income for the period would be about $7,000. $7,000 / a $100k cash investment = 7% profit per year.

When comparing the three scenarios, consider three things: the risk of not being able to pay the mortgages, the net cash flow, and the net income.

  • In the first example, you have no mortgage risk. This means that even if you never find a renter for the property, no bank can foreclose on the house, and you will still have that asset to sell if you need to. If all goes well, your net cash earned in the year is $5k, and your total return on your investment is 5%.

  • In the second example, you bought the same house, but if you don't find a renter, you will need to make those mortgage payments out of your own pocket, or risk the bank foreclosing on the house. If all goes well, your net cash earned in the year is only $2,000, but really your profit is $3,500 considering that you've made a $1,500 reduction in your mortgage principle. Because you only used $50k of your own money, your annual return on your investment is 7%. Also, because you only used $50k of your own money, you have cash reserves left over to pay the mortgage if a renter is not found.

  • In the third example, you have bought 2 houses. You used all $100k of your cash to do this, meaning you need to find renters or you will be unable to pay the mortgages and the bank will foreclose on your houses. If all goes well, your net cash flow for the year is $4k, but your profit is $7k. Your overall return is still $7k because you have doubled the size of your cash investment. This is the riskiest scenario, but it has the highest returns. Note also that in the first scenario, you received more cash in every year - from a cash perspective, avoiding a mortgage entirely was the best of the 3 options.

From a corporate perspective, the answer is the same: The more debt you take on, the more risk you have that you can't pay the banks. But, you will need less cash from your shareholders, meaning your shareholders' returns will be higher. This is called leveraging. It creates risk, but increases profits. Risk is highest when cash reserves in the company are low, as in the example above.

Grade 'Eh' Bacon
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In principle, higher debt is riskier when it comes to capital structure, but (as someone wrote above) you'd need to do a market survey of comparable companies. Each industry can be significantly different, as well as individual companies within an industry, so you'd take the median.

alyehoud
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