Richards (2013, p. 1) first sets out to define the terms to gain a better understanding of the concepts. “Debt” is defined as “borrowing money from an external source with the promise to return the principal, in addition to an agreed upon rate of interest.” Though the terms here are often understood in the negative light, startups, or small companies just beginning to operate, often use debt financing to fund their operations. In fact, even companies with the most robust balance sheets will often times reflect some amount of debt within. In financing terminology, debt can also be regarded as “leverage”, and the most popular source of locating debt financing is the banking sector; however, debt financing can also be provided by a financial institution or even by a family member or a friend.
“Gearing”, in terms of corporate financing, is commonly associated in describing the amount of a certain company's debt (net worth) as it is compared to the equity capital of the company. This figure is usually expressed in percentage form. Thus, if a company is “geared” amount of 60 percent, then the company has a 60 percent debt level compared to its equity capital. Here, the “gearing ratio” displays the level of restraint that its debt has placed on the activities of the company. The gearing ratio is not standard across the business and industrial sector; depending on the sector, a gearing ratio of 15 percent would be considered as a prudent number while a percentage of 100, and even above the number, would be regarded as a high risk or “highly geared” in terms of its debt levels (Finance Glossary, 2013, p. 1). Anderson (2000, p. 1) states that “gearing”, also known as “leverage”, can also be understood as the combination of long-term company funding that is provided on an internal basis, i.e., raised by the shareholders of the company, as it relates to the amount of financing that is raised by external means, i.e., by debt or other financing schemes and methods.
Hence, it can be said that if a company's financial structures are “over geared”, then the company's finances, or “books”, then the company has borrowed too much from external means to a degree that the company is finding it difficult or even defaulting on the payments due on the loan (Financial Times Lexicon, 2013, p. 1). However, it must be understood that analyzing company finances by using ratios as the sole basis will be deficient; the ratios are only mechanisms by which lenders or other users to acquire more knowledge of the company on a deeper scale-to use the mechanisms as a tool for decision making activities and control and administration/operation issues. In short, they are a way to acquire/accomplish an objective or a set of objectives, and must not be construed as the end itself.
Here, there are factors that must be considered to see if debt financing would be a suitable avenue for a company to pursue to fund its expansion. These are:
- Level of profits and sales of the company- Companies that have a good, stable or even solid profit and sales figure and projection are regarded as those that are in a better position to pay the interest as well as the capital payment charges than companies with risky and even low sales and profit figures. If a company have a higher sales and profits, then these have a higher chance of being able to successfully pay off their financial obligations.
- Interest costs- If lenders consider a company to be a high risk, then lenders are most surely to ask for a higher interest premium compared to companies who have stable financial positions. In the report of the Association of Chartered Certified Accountants (2008, p. 1), rising interest rates will result in an increment in the cost of lending to companies. In effect, corporate profits will be reduced, decreasing the level of available funds to the company to earmark for servicing loan payments.
- Rate of cash flow- The company must have a consistent cash flow level over the period of the loan for it to be able to service the financial obligations. According to Basu (n.d., p. 1), companies that are traditionally seen with positive cash flows include those from the technology, regulated, and from the service sectors; however, there is no distinction for negative cash flows, as the author sees this as a symptom that can be develop by any company.
- Industry characteristics- Lenders will inquire of the level of the “riskiness” of the industry where the borrower is located. In this light, companies situated in more risk laden sectors are expected to meet lower gearing ratios than those that are in more solid sectors.
- Disposition of critical stakeholders- Managers will be the ones ultimately responsible for the level of gearing that the company achieves, as they are generally in charge of the daily operation of the company. Nevertheless, the attitudes of the company's owners and the future and the prevailing cash flow rates of the company must be considered. Should the company assume additional debt loads, the value of the company is reduced, as credit agencies lower the credit rating of the company. In this light, shareholders will have reduced value for their holdings in the company.
- Equity financing resource availability- Should there be a restraint on the availability of additional funds that can be generated internally, a company must be able to prepare itself on short notice to secure outside funding and secure the needed possible resources to avoid defaulting or “passing up” an opportunity (Anderson, 2000, p.1).
In this light, the advantages, as well as the disadvantages, that companies can gain or acquire if they opt to choose debt financing as their avenue of expansion. Debt financing does have several advantages to it. One, sourcing funds via debt allows the owner of the company to maintain control and ownership of the company. Though the borrower is obligated to meet and comply with all the requirements of the loan, and to religiously make payments, that is the extent of control that the lender exercises over the borrower. Two, debt financing can help in lowering the amount of taxes that a company pays. In many cases, debts and the payments thereof are considered as business costs and can be taken off tax payments. However, as with any proposition, the positive will always be matched with a set of negatives. One, as mentioned above, the sole responsibility of the borrower to the lender is to make the payments on the loan incurred. However, in the unfortunate event that the borrower begins to have difficulty in paying the loan payments, the debt obligation remains; the obligation to pay the loan is not extinguished even if the company goes bankrupt. If the company declares insolvency, the creditors will have first option on the remaining assets of the company to satisfy the debts before the equity investors can make a claim. Two, given that a company maybe “over geared”, or loaded with too much debt, the banks may charge a high interest regime for the duration of the loan. Though “levering up”, or the practice of turning to the option of accumulating more debt to finance a project, may seem an attractive option for companies, these debts will reflect negatively on one's credit rating. The more that the company borrows, the higher the risk that will be shown in the company's credit ratings, and the higher interest premiums that a bank may charge against the company. Lastly, if the company intends to use the loan to invest in a project or acquire an important asset, the company must make sure that it will be able to generate sufficient funds to pay, or have enough collateral to place up front should the company default on the loan payments (Structuring Finance, 2013, p. 1).
For a company to be able to raise funds other than the method of debt financing, there are alternatives to incurring additional load debts. One is the possible exploration of debt relief mechanisms, which are also known as “debt restructuring” or “forbearance”. By restructuring the debt of the company, the company can conduct a renegotiation of the terms of the loan incurred, inclusive of the length and amount of the amortizations, the payment schedules and the conditions attendant to the loan. If successful, the borrower will be able to discharge a significant amount of resources that should have been allocated to the payment of the interest and capital of the loan. In addition, the company can use the cash from the loan proceeds to acquire assets and other capital to allow it to have a better financial condition, thereby allowing it to have a greater chance of being able to pay off its loan to its creditors. Also, by relieving the accumulating pressure that the company is experiencing due to the demands of meeting loan payments, as well as the reduction of the amount that should be allocated by the company in order to comply with the payment schedule, the lender safeguards his company from a debtor that is in high probability of defaulting on the loan, and increases the possibility that the borrower will be able to pay off the original debt amount, albeit on longer terms (Structuring Finance, 2013, p. 1).
If a company's financial output is encumbered and it is under threat of defaulting on its loan payments, or there is a large possibility that it will default, the options that are left to it are straightforward; either it can raise the needed funds by selling off some or all of its assets, or locate new financing schemes. These schemes can be reached via the supervision of the courts or by negotiated schemes outside the ambit of the courts. Either way, if a company is hard put to raise cash owing to its credit rating, then debt restructuring is a good avenue to pursue, as this creates value for the company, allowing it to operate, even though the company is transitionally over leveraged. However, in order to maximize the benefits of debt restructuring, it is best to opt for a negotiated “out of court” settlement so as to create the maximum value for the company (Gilson, 2012, pp. 23-24).
Aside from debt restructuring, Richards (2013, p. 1)mentions other possible avenues that companies can avail of when looking to finance activities or acquisitions without having to consider accumulating additional debt loads. One is “equity financing”, where the company can opt to sell shares or part of the interest to an interested buyer, or the owners and stakeholders can opt to invest in capital in the company, generating the funds needed from internal sources. Two, “mezzanine financing”, is where creditors offer the company “unsecured debt” instruments where the borrowing party does not need to set any collateral for securing the loan.
However, this type of instruments carry high interest rates, commonly ranging from 20-30 percent. Also, the lender has the right to convert the amount of the loan into equity in the company should the latter default on the payments of the company. Lastly, companies can opt to combine the features of these alternative types of financing, or as a “hybrid”. However, much of the knowledge in this type is anchored more on theory than application. In this light, for companies looking to capitalize on opportunities, “mezzanine financing” would be an optimal choice, as this offers instant liquidity, and though there is a risk that lenders can opt to convert debt into equity, banks are not that keen on becoming shareholders or even to take control of the companies to whom they extend loans.
Rond and Stone (2010, p. 1) state that owing to the recent movements and developments in the market has res-established the attractiveness of “mezzanine financing” as a tax-efficient resource for long term capital needs. With the decrease of the common “senior credit” and the hesitation of many banking institutions to lend money under the lax terms and low payment rates that have prevailed over the last decade, “mezzanine”, or “junior capital”, is seen as one of the most efficacious tools for owners of closely held of family owned businesses looking to acquire liquidity with the purpose of diversifying their company's asset base or to ensure smooth succession and financing internal growth activities.
“Mezzanine financing” is the part of the capital of the company that is lodged between the “senior debt” and the “common equity” as “subordinated debt” or “preferred securities” or in combination form. Business people as well as family held businesses invest the unstructured cash flows back into the company over a period of time, and owners will find that that the majority of their personal income is limited by the company. If the company is pursuing a one-time asset acquisition or activity, diversifying the company's income base as well as relieving and retiring some of the organization's outstanding debt payments. In the estimation of Thomson Reuters, more than $25 billion has been generated by way of limited or short term mezzanine financing since 2008. However, there is no single type of financing that is tailor fit to meet all the needs of borrowers; companies must be able to examine what type and the state of their company before these options can be evaluated and engaged. For companies that cannot avail of debt financing or when debt financing would worsen the rating of a company, “mezzanine financing”can be considered to raise liquidity. In addition, it will place less strain on the financial resources of a company, and is less restraining than bank debt resources (Mezzanine Management Central Europe, 2008, p. 1).
Bibliography
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