Does Business Debt Increase Volatility?

 Today, I have an interesting question from Eugene: “Doesn’t having business debt make a business more volatile?” Let’s dive in. https://youtu.be/YH8WzjkDU-A

The Common Misconception

Eugene's assumption is understandable but not entirely accurate. Having debt in a business does not inherently make it more volatile. However, the key issue is how that debt interacts with the business’s cash flow and overall stability.

The Role of Debt in a Stable Business

Debt can be a useful tool for a business with steady and predictable cash flow. Here’s why:

1. Boosts Return on Equity: Debt can amplify the returns for equity investors. If you demand a high return on your investment, using debt can enhance those returns. For example, borrowing at an interest rate of 5-6% can be significantly cheaper compared to the return you might expect on your equity investment.

2. Fixed Payments: With debt, the business commits to regular payments. If the business has a steady cash flow, it can manage these payments without issues, making the use of debt advantageous for growth and expansion.

Volatile Businesses and Debt

While debt doesn't make a business volatile, volatile businesses should generally avoid debt. Here’s why:

1. Unpredictable Cash Flow: Volatile businesses often experience fluctuations in revenue due to factors like seasonality, market conditions, or economic shifts. This unpredictability can make it challenging to meet regular debt obligations.

2. Risk of Default: If a volatile business cannot meet its debt payments during a downturn, it risks defaulting on the loan, which can lead to severe financial consequences, including bankruptcy.

Equity vs. Debt

In volatile or high-risk industries, such as IT startups, businesses often seek equity financing rather than debt. Equity investors share in the risk and don’t require fixed payments, making this a more flexible option for businesses with uncertain futures.

Government Guaranteed Loans

One scenario where startups might acquire debt is through government guarantees. These programs enable new businesses to borrow based on projections, despite lacking a proven track record. While this can provide initial capital, it also increases the risk if the business cannot generate the projected cash flow.

Conclusion

So, Eugene, the answer to your question is nuanced. Debt doesn’t inherently increase a business's volatility, but volatile businesses should be cautious about taking on debt. For businesses with steady cash flows, debt can be a strategic tool to enhance returns on equity. However, businesses with unpredictable cash flows are better off avoiding debt to prevent financial strain.

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