I will start by admitting that I am not a financial professional. Thus, this blog is mainly directed toward those running a privately owned business (Owners/CEO’s). The question is what is the best capital structure (debt, equity, cash) for a business in the industrial products manufacturing area? Financial professionals would argue the mix which delivers the lowest average cost of capital. I believe in a low interest rate environment, if you are not leveraged to some extent, you are mismanaging an opportunity for increasing enterprise value. I would also argue (as I do below) for maintaining a certain percentage of available cash on hand.
If you start with the premise of dividing the three components of capital structure into thirds, that means you have equal parts cash, debt, and equity. Then based on the cost of the debt and equity component, rebalance to give you the lowest average cost of capital. In today’s low interest rate environment, “lowest cost of capital” thinking would drive you toward the debt market. However, nothing good lasts forever and interest rates will go up eventually. As a good forward-thinking Owner/CEO, you should be preparing for this eventuality by maintaining a good amount of cash on hand for “a rainy day” fund. Assuming your enterprise is a private entity and we go by the conservative view of a debt to equity ratio of no greater than 50%, then you should have the other 50% in a cash account invested in very safe and liquid assets. You should also be managing cash flow with ferocity. Strive to attain a 100% free cash conversion ratio of operating profit before interest, dividends, and taxes. Attain enough free cash flow from operations to cover your interest for debt payments three times.
By now, you are probably saying that this approach is much too conservative. I argue that if you use this approach, it will pay off for you in the future when the days of recession and/or higher interest rates hit. When this happens, your business will likely be in a better position from a capital structure viewpoint than your competitors. Yes, you should be thinking of beating your competition in capital structure. When a difficult business environment arrives, you’ll have the capital needed to easily handle your debt requirements and continue investing in your business. This position will enable you to further distance your company’s performance from your competitors. Additionally, you’ll have the capital structure to take advantage of a once in a lifetime investment opportunity if it presents itself, like buying your competitor out at a bargain basement price.
December 12, 2019