Sebastian Perrier

In choosing between Debt or Equity financing, a good way to analyze the decision is to use the FRICT model. Not that the financing decision is a separate analysis from the investment decision.

1. FLEXIBILITY: debt reduces flexibility because in the future, if you want to raise more money, maybe your only option will be equity because you are highly leveraged. On the other hand, equity provides you with flexibility.
2. RISK (leverage): compare with the industry the levels of leverage vs their P/E ratio. If companies highly profitable and with high P/E ratio are more leveraged than you, maybe you’re under leveraged. Also see your times interest ratio to see if your level of financial risk (leverage) is appropriate to your industry.
3. INCOME (EPS): more debt provides a tax shield and increases profitability and EPS.
4. CONTROL: in terms of debt, the bank usually puts you restrictions which can limit your control. Equity stakeholders may take control if they have more than 50% of the shares.
5. TIMING: whether to finance with debt or equity is also a matter of timing, for example, if at that point in time interest rates are low or maybe the price of your stock is too low to raise funds, etc.

Deciding how to finance the company assets is a separate decision. The financial decision and the investment decision for example, are different things and should be considered separately.

In what regards to the financing decision, the main thing to consider is whether to finance with debt or with equity. Debt is less expensive but it is more risky while equity is more expensive and less risky.

See in the following example two companies which have the same Income Statement, they are equally profitable, but they are financed in different ways:

-> Download spreadsheet with example.

In Scenario 1: Company 1 is 20% financed by debt while Company 2 is 80% financed by debt. Therefore, although both companies have an EBIT of US$200, Company 1 has a ROE of 11% while Company 2 has a ROE of 30%. Investors in Company 2 will have a higher return on their investment because the interest payment is before tax, thus interest expense provide a tax benefit over Company 1.

However, Scanario 2 shows how Company 2 is more risky. If EBIT decreases to US$60, Company 1 remains profitable while Company 2 will become unprofitable.

While the Income Statement reports on the company’s profitability over a certain period of time (in general one year), the Balance Sheet provides a snapshot of a business financial position at a specific point in time. Thus, the balance sheet captures the cumulative effect of financial decisions made in the past.

• Current assets: liquid assets that can be converted into cash within the firm’s normal operating cycle.
• Receivables: payments due from its customers for previous credit sales (current asset).
• Inventories: raw materials, work in progress and finished products held by the company for eventual sale.
• Fixed Assets: gross fixed assets – accumulated depreciation (net book value=non-current asset).
• Payables: outstanding credit payable to suppliers withing 12 months (current liab).
• Accured expenses: short-term liabilities that have been incurred but not yet paid (current liab).
• Long-term debt: loans from banks or other sources with repayment terms of more than 12 months.
• Owners Equity: owners investment in a company plus retained profits reinvested in the firm less dividend paid.

ASSETS=LIABILITIES + EQUITY

Assets are financed by creditors and owners money. Assets are used to generate a profit and thus a return on investment. The best way to measure a company’s profitability is return on assets or operating profit / total assets.

What is the Balance Sheet useful for?

1. A. it allow to see how the company is financed.
2. B. by comparing year 1 BS vs year 2 BS we can see how the company is using/investing the money and how much return is that money generating.