Cash & Liquidity ManagementStriking the right balance between debt and equity in capital structure

Striking the right balance between debt and equity in capital structure

No two companies are alike, and neither are their funding needs – but all organisations need a sustainable capital structure to grow and deliver returns. Unfortunately, striking the perfect capital balance can be tricky writes Nash Riggins.

If companies want to survive and prosper, they’ve got to establish a sustainable capital structure – there’s simply no way around it. That’s because a firm’s capital structure not only helps treasurers to consolidate a company’s financial strength, but it also ensures there are plenty of doors left open to that organization to pursue new and ambitious growth opportunities. Likewise, the ideal capital structure should also empower companies with enough flexibility to weather any unforeseen economic storms that may arise.

That being said, finding and maintaining the perfect capital structure can be a pretty tricky balancing act for most corporates.

Capital structure balance is normally upheld by establishing a company-tailored equilibrium between debt and equity. Both of these funding methods come hand-in-hand with their own unique sets of advantages and disadvantages, which is why the vast majority of treasurers devote a lot of their time and energy towards utilizing a combination of the two to ensure their respective organizations are effectively funded to meet any unique long-term objectives.

Unfortunately, there’s no magical formula a company can achieve to establish supreme financial harmony. There are rough guidelines surrounding a company’s ideal debt-to-equity ratio, sure – but at the end of the day, each firm must carefully weigh the pros and cons of debt and equity in order to strike the perfect balance that works for their business.

While there may not necessarily be any universal targets treasurers should chase after in their never-ending mission to establish a healthy capital balance, there are several general considerations that are definitely worth bearing in mind.

What’s the difference between debt and equity capital?

While debt capital and equity capital share an equally critical presence within a company’s capital balance, the similarities between the two funding methods effectively stop there.

Debt capital describes the funds a company has borrowed from a lender in order to finance business activities that will need to be repaid. This borrowing normally manifests itself in the form of long-term business loans, or a number of short-term borrowing facilities like overdraft protection.

A positive element of debt capital is that it doesn’t dilute shareholder interest in a company. Likewise, until fairly recently debt has been incredibly cheap thanks to more than a decade’s worth of historically low interest rates across a range of key markets. These low rates are a huge reason why debt has been a very attractive way to generate quick cash to fund growth – and according to the Securities Industry and Financial Markets Association, it’s also why corporate debt in the US alone has skyrocketed from just $4.9 trillion in 2007 to almost $9.1 trillion last year.

Another point worth considering is that payments towards debts or interest paid on debts are normally tax-deductible in the vast majority of regulatory jurisdictions. Yet with central bankers across the globe now implementing small but steady rate rises, any over-reliance on all of that quick cash generated through debt could soon start to throw debt-to-equity ratios off kilter and drastically weaken capital balance.

By contrast, equity capital specifically refers to the funds paid into a business by shareholders. This makes the cost of equity a bit more complex, although it normally takes the form of common stock, preferred stock or retained earnings. That means equity is a reflection of ownership, whereas debt is a reflection of liability. It also means that by taking on loads of equity, shareholders will inevitably be diluting their overall ownership of the company.

Equity is often considered a great way to fund a business because it enables companies to power strategic initiatives and strengthen working capital without taking on new debt liabilities. That being said, equity financing does come with the added pressures of investor expectations around returns and market performance. Valuations and dividends paid will often need to meet or exceed ambitious pre-defined levels in order to retain that investment.

Despite increasing borrowing rates, the cost of equity is still typically going to be higher than the cost of debt – although by contrast, equity financing will normally bring in more cash than debt and offers improved flexibility in terms of how that cash can be allocated and distributed.

How can you strike the perfect capital balance?

When working to find and maintain a sustainable and efficient capital balance, all treasurers should be looking to take actions and deploy funding methods with the intention of minimising their company’s Weighted Average Cost of Capital (WACC) – because any increase in WACC will subsequently signify a decrease in company value and a simultaneous rise in risk to both lenders and investors.

Likewise, treasurers need to keep an eye on their organization’s debt-to-equity ratio.

Although different ratios work for different companies, it’s fair to say that most corporates shoot for a maximum ratio of 1:2, in which the value of equity capital is double the amount of debt capital. This is recommended by many financial professionals because a substantially larger proportion of equity offers a guarantee that the organization will be able to efficiently and sustainably cover any losses incurred – although if companies go any higher in terms of equity, shareholders can be weakened and returns will likely drop in line with that diminished authority.

Yet it’s worth noting debt-to-equity ratios will fluctuate pretty dramatically throughout the lifetime of a company as debts mature or market conditions shift. That’s why there’s no magic number or failproof solution all treasurers can stick to in terms of striking a textbook capital balance.

Even so, corporates have got to tread carefully, here. This is why there are several crucial factors financial leaders should bear in mind before taking actions to pursue new funding.

For example, flotation costs should play a huge role in the decision-making process, because if an investor is charging large amounts to float shares, then issuing debt could be far cheaper in the short-term. The same could be said about rising interest rates, as high borrowing rates often mean companies will have to offer up large coupon bonds to sweeten the deal and attract investors.

Meanwhile, high tax rates could slash bondholder returns, and companies with volatile earnings may find it difficult to guarantee sufficient cash to cover coupon payments. Younger companies requiring serious growth or a reliance on research and development would also ordinarily do well to reduce too many claims on cash flows by opting to issue equity rather than take on debt.

Finally, a huge proportion of work surrounding capital balance is based on intensive research. To find balance, companies must check out competitors, and also conduct regular and thorough internal investigation alongside stakeholders to develop a firm idea of organizational requirements in terms of forecasts, strategic plans and the ideal financing methods that will best compliment those plans.

Striking the perfect capital balance is never a straightforward task. It’s an ongoing responsibility that calls for constant monitoring, auditing and adjustment – and it can be a major headache at times. Yet by asking the right questions, appropriately weighing all available options, demonstrating patience and paying constant attention to a company’s ongoing cost of capital, it is possible for treasurers to establish relative harmony between debt and equity.

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