Debt, equity and raising capital: how companies fund growth
Every company has to decide how to pay for growth, and what to do with the cash it generates. Those choices, made by management, often matter as much to shareholders as the business itself.
Two ways to raise money
Debt (loans and bonds) must be repaid with interest, whatever happens. It is cheaper than equity because lenders get paid first and interest is tax-deductible, but it adds fixed obligations. Equity (selling new shares) never has to be repaid, but it shares future profits with new owners and dilutes existing ones.
Measuring leverage
| Measure | Formula | What it tells you |
|---|---|---|
| Debt-to-equity | Total debt ÷ shareholders’ equity | How much of the business is funded by lenders vs owners |
| Net debt / EBITDA | (Debt − cash) ÷ EBITDA | Roughly how many years of earnings it would take to repay debt. Above about 3x deserves scrutiny |
| Interest cover | Operating income ÷ interest expense | How comfortably profits cover interest. The higher the safer |
| Debt / capital | Debt ÷ (debt + equity) | The share of total funding that is borrowed |
What’s “safe” depends on the business. A utility with stable, regulated income can carry far more debt than a cyclical tech hardware maker. Check when debt matures too: debt raised at 2% that has to be refinanced at 6% can hit earnings hard.
Leverage cuts both ways
Debt magnifies returns to shareholders in good years and losses in bad ones. In a downturn, a company with heavy debt can be forced to sell assets, cut dividends or issue shares at the worst possible price.
Raising equity
- Placings and rights issues: selling new shares, usually at a discount. A rights issue lets existing shareholders buy first to avoid dilution.
- Share-based pay: a quiet, continuous form of dilution, especially in tech.
- Convertible bonds: debt that can turn into shares. Lower interest for the company, potential dilution later.
Raising equity to fund high-return growth can be good for shareholders. Raising it because the business burns cash with no end in sight is a warning sign.
Returning cash
Dividends pay cash directly. They are only sustainable if covered by free cash flow, and a very high yield often means the market expects a cut. Buybacks reduce the share count, so each remaining share owns more of the company. They create value when shares are bought below intrinsic value, and destroy it when management buys at any price to prop up EPS.
Judging management
Capital allocation is the core job of a CEO. Useful questions:
- What return on capital does the business earn, and is it above its cost of capital?
- Have past acquisitions created value, or been written down later?
- Do buybacks happen when shares are cheap, or only when they’re expensive?
- Is pay tied to per-share value and returns, or just to size and adjusted EPS?
- Do insiders own meaningful stock, and are they buying or selling?
Key takeaway
Two companies with identical businesses can deliver very different returns depending on how they are financed and how management uses the cash. Read the balance sheet and the capital allocation track record, not just the income statement.
Educational content only, not financial advice. Investing involves risk and you can lose money.