Owners and managers of businesses always have the option of financing a business by way of either debt or equity. For any business, there is usually an optimal debt to equity ratio that best fulfils the objectives of owners and managers and which depends on a number of factors.
There are numerous advantages to financing via debt. Debt has the advantage of generally being tax deductible (although tax regimes in some countries do set a limit on the amount of debt which is deductible), and debt financing has the advantage of avoiding dilution of equity ownership. The cost of debt financing is therefore lower than the cost of equity.
However the big disadvantage of debt financing is that it increases the level of risk in the corporation (i.e. there is a higher risk of default). Moreover, as the level of debt increases in a company, the cost of such debt also tends to increase so as to compensate for the additional risk.
There are also a number of cyclical factors that may have an impact on the debt to equity ratio. The expected debt to equity ratio varies depending on whether markets are bullish or bearish, whether the economic sector to which a company belongs is more sunrise or sunset, or indeed on whether a company is in an early development phase or at maturity.
During the last economic boom, most business owners would have preferred a higher mix of debt to equity as debt was readily available, interest rates were lower, companies had more accurate earnings forecasts, and earnings tended to rise over time. Expansion could be financed via debt, while existing equity owners remained in control, and interest was tax deductible.
However, during the current recession, earnings are much more difficult to predict (companies often have trouble forecasting for the coming quarter, let alone for the year) and debt is much less readily available, as a result of the much more conservative lending policies the banks are adopting. While interest rates such as Euribor, Libor, etc. have decreased by several percentage points, the spreads over Euribor or Libor have generally increased by anywhere from 100 to 400 basis points for most companies, meaning that the real cost of debt financing (after adjustment for inflation) has generally increased.
The word ‘deleveraging' often arises during the current recession. The dynamics described above generally force companies to substitute equity for debt. However, equity has also become more difficult and costly to source during the current recession, compared to 18 months ago. Equity as a source of financing has not disappeared. Both financial and strategic investors tend to be opportunistic during a crisis. Beefing up the balance sheet with a healthy dose of equity is an option that a majority of business owners and managers should be considering today.
In addition to the option of equity injection, hybrid instruments, (e.g. which contain features of both debt and equity) may also strengthen a company’s financial position. Two common hybrid instruments are preferred shares (which have an obligation to pay a certain dividend rate), and convertible debt (where the lender may be willing to accept a lower interest rate in exchange for having the option to convert the debt into equity at a later date). Hybrid instruments typically have a level of risk that is higher than debt but lower than equity, and therefore the cost of financing also lies somewhere between the cost of debt and the cost of equity.
A strong balance sheet can be even more a source of strength and competitiveness in a recession than during a boom. It is no accident that even strong banks such as HSBC are raising equity, not because they are undercapitalized, but to take advantage of opportunities in the marketplace. Equity may also be viewed as a financial cushion, something that would help companies weather a deepening recession, in the event the much-touted recovery does not occur as soon as we expect.