Capital Structure in Business and Personal Balance Sheets

by JT McGee

Mind your capital structure in business and personal budgets.Last week I posted about my own stock portfolio. Being the fan of low cost debt that I am, I realized how ridiculous it might be that many of my equity selections are debt free. Why is it that I can dig zero debt even with a high ROE business model?

Because there are times when leverage doesn’t make very much sense.

In looking at my selections, most of them are micro-cap stocks. Just like people with bad credit scores, micro-cap companies have a really hard time accessing the debt markets for low-interest, long term debt.

A Problem of Capital Structure

When we look at how to structure our budgets for business and for personal balance sheets, it’s important that we keep our eyes on the prize (safety) while seeking out the best possible return for our money.

One of Peter Lynch’s best tips is to never buy a company with bank debt, and this makes a lot of sense. Bank debt, much like open-ended lines of credit for individuals, is callable. Basically, at any time the bank can change the terms to increase the monthly payment as a percentage of the debt, or decrease the available balance for borrowers.

Imagine that you’re running your budget based on a home equity loan for $100,000. Pending that the line is always available, it works great as a mechanism to smooth out periods of weakness in cash flows. However, it can also create a really sour problem really quickly in that if it disappears, your personal budget is screwed.  Do keep in mind that a minority of business loans are callable; however, note that the lowest rate loans are ALWAYS callable.  According to BusinessWeek, callable loans make up no more than 25% of all business loans issued by dollar amount.

The Financial Crisis

During the financial crisis of 2008 I got quite the shock. I lost a full quarter of my available credit lines, most of which stemmed from one credit card. My available credit from American Express went straight to $1000 (a pittance, really) while other cards stayed flat.

Fast forward to today and that stupid American Express card still isn’t worth more than $1000. Guess what? I never use it. It doesn’t make sense to use a card when I spend enough in one month to put it over a level of utilization that would kill my credit score, which would only stand to affect my ability to borrow elsewhere.

Had I relied on only one card, I would have been stuck between a rock and a hard place.

When businesses rely on callable debt, or open-ended lines of credit, they expose themselves to weakness from an individual creditor as well as the broad economy. When looking for small companies, I don’t want any more exposure to the broad economy than I need. Buying companies with levered balance sheets and tiny market capitalizations is a great way to expose my portfolio to one failed bank, a systematic risk. I just won’t do it.

As it stands, the terms of the credit facility for the recently announced merger happening in my portfolio are not available. GE Capital is doing the fundraising, so it will be important to see how it’s structured. If it’s non-negotiable, non-callable, and generally low interest, I’ll hold on. Otherwise, I’ll simply have too much risk to make my ownership worthwhile.

So that is, in a nutshell, why leverage isn’t always a good thing.

Photo by: JD Handcock

{ 4 comments… read them below or add one }

Dave @ Money In The 20s July 6, 2011 at 11:17

As usual, well written!

Perfect example of why leverage isn’t always good.

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JT McGee July 9, 2011 at 07:54

Thanks, Dave.

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Financial Success for Young Adults July 6, 2011 at 13:22

Man, it’s a good thing that Storm Trooper has an umbrella. I was getting scared that he was going to get rained on! Especially standing on that tin roof! lol

But in a more serious note, I like using leverage in a manageable fashion. For example, I don’t leverage my equity positions because I buy and hold long term. There’s no reason for me to buy on margin when the return over time could be eaten away by the interest rate.

However, I will use leverage in my foreign exchange accounts because I am in and out of those trades usually in about a day or two. Some trades even a few hours. I can gain a larger return (or loss) using leverage on a risky asset. But I just trade forex for fun. It’s not a long term retirement play so I don’t mind.

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JT McGee July 9, 2011 at 07:55

Yeah I have nothing against leverage on my own balance sheet if I know that I can sustain it. With small cap companies and leverage, meh…sometimes they get burned on a closing line of credit.

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