All companies need cash to finance their activities, whether these be simple operating activities, investing or financing activities. A company may not be able to finance its own activities through the cash it generates from its operating activities alone, and therefore may need to find additional external sources. However, the way that they procure this finance may be done by two means; acquiring equity or debt.
Equity is the ordinary share capital that is essentially the money the owners (shareholders) have put into the company. Equity is associated with both business and financial risk, and this is expensive to the company as investors expect a greater return the more these risks increase.
Debt is a contractual obligation to pay interest on money borrowed by the company, and unlike equity (dividends), it must be paid. Debt is only associated with financial risk since these debts can be secured and are a matter of contract, and thus is cheaper to the company.
Equity is much more expensive than debt because the risk associated with equity is much higher that that of debt. This risk is due to the fact that equity return is based on the company’s ability to generate profits, since dividends are paid out of profits (realistically cash), and as there is a higher risk, the required return is greater. Similarly, the interest that must be paid on debt is a tax-deductible allowance, and therefore is cheaper than equity.
Capital gearing is the relationship between the equity and debt in the company’s capital structure. As the capital gearing increases (due to increased debt), the financial risk also increases. Financial risk is only associated with borrowed money, and is effectively the level of interest that must be paid – the greater the amount of interest that the company is obligated to pay, the greater the financial risk of the company not being able to meet those obligations. This financial risk is bore by the shareholders, and therefore, as the financial risk increases, they require a greater return, increasing the cost of equity even more.
Initially, the weighted average cost of capital will decrease due to the lower cost of debt. However, after a certain point, the capital gearing ratio will increase, and therefore the increased financial risk will negate the lower cost benefits of debt. This is why many companies don’t take on large amounts of debt, but do take some on for the benefits stated above i.e. tax deductible and cheaper.
Therefore, in conclusion, equity should not be minimised, nor debt maximised, but instead a good balance of the two should be made to balance financial and business risk with the benefits of each. However, this balance will heavily depend on the industry that a company operates within – some businesses need to be highly geared, and others lowly geared. Similarly, some businesses such as start-up business may not in fact have a choice but to use equity, as their sources of finance are much more limited (see ‘The Funding Gap’ chapter in my article on ‘Macroeconomics and monetary policy: the basics’).
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