Why Does a Company Use Debt?

By Sean Ryan, CFA

Companies use debt to increase the owners’ profits.

Typically, a company will borrow money – either through a loan from the bank, or through bonds sold to investors – in order to expand. If a company wants to open a new factory, or a new store, but doesn’t have enough money on hand to do so, then it may borrow the money to finance its growth.

Companies with little or no growth can still use debt to increase owners’ profits, however. A company with little or no growth obviously doesn’t need to borrow money to expand. However, sometimes a slow-growing but stable company can borrow money in order to reduce the amount of money the owners have to keep tied up in the business. This allows the owners to invest that money elsewhere, increasing their profits.

The trouble with borrowing money, of course, is that eventually it has to be paid back.

The company that borrows money in order to expand is taking the risk that the expansion will turn out to be unprofitable. Even if it is unprofitable, the company still has to repay its loans. If it cannot generate enough income to keep making the payments on its debt, then its lenders may take over some (or all) of the company, leaving the original owners with little or nothing.

The funny thing about debt is that its typically cheapest for those who need it the least, and most expensive for those who need it the most. If a company is doing so well that it doesn’t really need to borrow money, lenders will tend to charge a lower interest rate, because they know the risk of not getting paid back is small. Yet if the same company falls on hard times, and needs to borrow money to stay in business, lenders will see that the risk of not getting paid back is higher, and so charge a higher interest rate (or maybe even not lend money at all).

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