When considering how a company should finance itself, lots
of factors need to be considered! The first of which is equity or debt?
Should a company opt to fund itself through equity such as
listing on the stock exchange? Well it has its benefits…the company can raise a
lot of money but at a huge cost to itself and a highly complex process.
However, massive funds can be raised and the reputation of the company is
usually enhanced dramatically. Yet, those costs as well as the loss of
ownership and the responsibility to the shareholders is a daunting factor, even
though the company doesn’t necessarily have to pay the money back through
dividends! Though when looking at this option of equity finance…the negatives
do seem to outweigh the positives. So debt finance is the left over option.
What is so great about debt finance?
Well it’s simple, less risky and as a result much lower
cost. So why don’t all companies just finance through debt? One answer is
because it doesn’t look great…the more debt you accumulate as a company the
higher risk you are and therefore the costs start to rise in conjunction with
that. Another consideration is that companies use their capital structure as a
competitive advantage, but how?
If debt is much cheaper than equity, it’s obviously going to
be first choice for companies! They want the cheaper option because it looks
better to their investors. However, as mentioned above the more debt they get
the higher the costs! So once the debt becomes too expensive, what can companies
do? They can aim to find the perfect capital structure, the point where debt is
equal to or less than the costs of equity, and then they stop funding through
debt and switch to equity finance! How is this gaining competitive advantage
though?
If a company finds the perfect equilibrium then they will
essentially become a magnet for investors, they will have enough finance to improve,
grow and innovate within the company. This compared to a competitor who is
riddled with mass amounts of debt, or who has no debt but massive costs in
terms of equity finance, is brilliant! They have the upper hand because their capital
structure provides them with enough money which isn’t too expensive for the
business to reach its potential.
One company who has seen the effects of a bad capital structure
is peacocks. The well known high street store has entered administration and
the reason behind the companies collapse was an unsustainable capital structure
as well as a surplus of stores (BBC, 2012). Thomas Cook is also a high street
holiday provider who is suffering due to massive amounts of debt, which have led
to a poor capital structure. Although not in the same position as Peacocks, it
is still struggling- ‘The Company’s board is also taking steps, including a
strategic review, to reduce the group's debt "and reach a more appropriate
capital structure over time".’ (BBC, 2012)
This emphasises the problems have a bad capital structure can
cause, yet many companies have good capital structure in place. These are the
companies who have found the balance between debt and equity finance, and they
are the companies who will gain and take advantage of their competitive position.
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