A key priority for management teams is maximizing shareholder value by balancing stability and growth. While relying on stable cash flows may provide short-term security, technological advancements and market shifts can challenge companies that fail to invest in their future. Conversely, excessive reliance on growth can expose a company to undue financial risk, as ramp-up periods and investment uncertainties may strain cash flows.
Effective growth planning requires identifying the right opportunities based on expected returns, which in turn must align with a company’s funding strategy and capital structure. At a high level, businesses have three primary sources of funding: internally generated funds (i.e., balance sheet cash), debt and equity. Each carries its own risks and rewards, with balance sheet cash offering the lowest return potential and equity the highest. Debt capital sits in between, with a variety of providers offering unique advantages and considerations.
Rewards of Debt Capital
External capital—both debt and equity—enables companies to accelerate growth. While this discussion focuses on debt financing, equity may also play a role in the capital structure depending on the company and project-specific circumstances.
Borrowing allows a company to execute strategic initiatives today, using future cash flows from those projects—along with existing operations—to repay the debt. However, to justify taking on debt, projected returns must exceed the cost of capital, making it essential to carefully evaluate the type and amount of financing.
Another advantage of borrowing is the preservation of balance sheet cash. While using internal funds is generally the lowest-cost option, maintaining cash reserves provides financial flexibility. This is particularly valuable for managing unforeseen challenges, extended payback periods or unexpected cost overruns. Relying solely on internal cash could place undue strain on the company if the project encounters delays, exceeds budget or underperforms in its early stages.
Determining how much to borrow and structuring the capital stack appropriately is critical. For further insights, refer to a recent article, “Considerations for Optimizing Your Capital Structure.”
Risks of Debt Capital
While debt financing offers several benefits, it comes at a cost—namely, the obligation to repay principal and interest. These payments require careful cash flow management, as they must be balanced alongside working capital needs and other financial commitments. This is particularly relevant for Employee Stock Ownership Plan (“ESOP”) companies, where additional cash outflows may impact the company’s ability to satisfy repurchase obligations. A thorough review of ESOP sustainability and repurchase obligations is essential when evaluating debt financing options.
In addition to cash flow constraints, taking on debt reduces a company’s future borrowing capacity. For example, if a company can sustain a Total Debt to EBITDA ratio of 4.0x and secures 2.0x EBITDA in financing from a senior lender, that funding source may not be available again until a portion of the loan is repaid. If the company later faces volatility in earnings or unexpected expenses, it may need to explore more expensive financing options.
Consider a company that uses 2.0x EBITDA in senior debt to fund a repurchase obligation. If an urgent capital expenditure arises six months later, it may need to rely heavily on balance sheet cash or seek higher-cost junior capital, as its senior borrowing capacity has been exhausted.
Additionally, debt instruments are highly sensitive to interest rate fluctuations. Companies using floating-rate debt face increased interest rate risk—if rates rise or remain elevated longer than expected, interest expenses increase, and early principal repayments may be restricted. Conversely, if rates decline, borrowing costs decrease, and companies may accelerate debt repayment. Given this uncertainty, businesses should consider hedging strategies such as interest rate swaps or caps, each of which carries its own risks and benefits.
Conclusion
Debt capital can be a powerful tool for driving shareholder value and preventing business stagnation. However, the debt capital markets are complex, offering a wide range of financing solutions tailored to different business needs. Start by targeting a capital structure that satisfies the company’s current needs, while maintaining dry power for unforeseen circumstances or opportunities (i.e., soft operations or acquisitions).
If your company is exploring strategic initiatives that require external funding, Prairie Capital Advisors can help you assess capital requirements, determine debt capacity, explore financing options, optimize your capital structure, connect with capital providers and execute a successful debt capital raise.
Joseph Labetti is a Vice President at Prairie Capital Advisors, Inc. He can be contacted at 630.413.5586 or by email at jlabetti@prairiecap.com.
