Difference between Debt and Equity Finance - Example

Financing a UK listed Fashion Retailer Contents Contents 2 Difference between Debt and Equity Finance 3 Types of Finance available for a UK listed company 5 Debenhams market value and finance needs over the last 3 years 6 Justification and Articulation of recommended approach 9 Reference List 11 Difference between Debt and Equity Finance Firms in UK have heterogeneous preferences, as far as capital structure decisions are concerned. Some firms want to base their finance decisions on trade off theory by maintaining a certain ratio between debt finance and equity finance. Other firms want to follow the pecking order theory, where they first select the least risky source of fund and then go about choosing funds with higher risk, depending on the nature of requirement. Debt funds are also determined after consideration of the interest tax shield, repayment schedule, agency costs and institutional differences. Additionally, characteristics of each firm, in relation to business risks and opportunity for investment, affect contracting costs. Such costs also determine the choices of alternative sources of funding between equity and debt (Beattie, Goodacre and Thomson, 2006). The various sources of finance, which are available to a growing or a newly established company, are numerous. Each company is in constant need of capital for financing the growing business needs. The difference between the purpose and also the financing needs determines the source of finance. However, there are certain key differences between debt and equity financing, which determines the source of capital that a company should use in order to finance its business needs and that which shall prove to be the most beneficial (Gov.uk, n.d.). Function Based on the premise of function, debt and equity financing provide means to companies for sourcing huge amount of funds for the purpose of new product development or expansion of business. The two sources differ by way of whether the company prefers to borrow money or raise money. Debt financing relates to borrowing of funds for the purpose of current use and for paying it off, when the need has been fulfilled. Equity financing involves sharing a certain percentage of company ownership by selling such ownership to investors for personal need fulfilment. Ownership Another difference between the two sources of financing is noticed when the company has to decide over the level of ownership that it desires. While considering debt financing, companies have to source loans from banks and financial institutions or by issuing bonds. While considering finance through the equity way, companies raise capital by way of issue of shares over the stock market or of private offers. Use of debt finance allows for considerable amount of freedom and ownership is retained completely within the business. Equity financing brings in ownership division and distributes ownership among a new set of equity finance holders. Companies that use debt funds have to pay back the money and need not compromise on the ownership or the built up capital, with use of such debt through the years. Equity financing requires division and distribution of profits earned between additional shareholders as well. Risk The primary difference between debt and equity finance has to do with risk types that are involved. Debt finance uses loans and bonds to get capital and companies need to use repayment schedules, in case of debt. Periods of high cash flow or low cash flow is not considered in such schedules. Any interest cost associated with debt financing raises the amount of money or cash flow needed, in order to break even, while considering coverage of operational expenses. Companies do not have any obligation for repayment, while considering equity finance. Even so, decision making power of the board is diluted by rise in the number of shareholders; in case of funding via equity finance (Ross, et al., 2009). Profit Debt finance has no effect on equity holdings and offers more profit per shareholder than in case of equity finance, where the number of profit sharing shareholders increases, which might not raise the profit per shareholder by a considerable amount. Therefore, companies should use equity funding only when they seek to strengthen their firm’s ability of raising debt capital. Debt funds can be used to write off tax requirements through interest costs. This in turn reduces the company’s total cost of loan funding. All the above discussions might make debt capital seem as a more attractive choice for a company listed in UK. However, it is to be noted that equity funds have their advantages as well. It has lesser risk associated in comparison to loan. In addition to funds, equity funding also lends increased credibility to business, unlike debt funds. Profit sharing is limited within the shareholding community and need not be used in repayment of debt obligations. In the event of business failure, such funds do not require any payback for investment (Pattani, Vera, and Wackett, 2011). Types of Finance available for a UK listed company Finance can be raised through numerous ways in a business. Such types of finance choices are dependent on a number of factors, including nature of business, purpose for funding requirement and size of business activity and scope. Larger organizations have more choices of funding than the smaller ones. Apart from savings, which is probably the more obvious way of funding, business have options like, equity funding, loans, debt securities, so on and so forth. Small businesses can borrow from families, friends as well as banks and financial institutions. In contrast, companies can raise funds by way of issue of shares. Figure 1: Sources of Finance (Source: Thetimes100, n.d.A) The first source of finance for listed companies is borrowing from banks and other financial institutions. Loan is just a sum of money that can be lent out for a specified period of time and repayment has to be made with periodic interest. For the purpose of lending, banks and financial institutions look into all types of opportunities and risks involved within business of the company to which it is lending. Lending, thus, requires a careful and extensive business plan. In order to lend, the lender demands some sort of security against the money that is provided, in case the business runs into a financial crisis (Financial reporting Council, 2009). A second way of funding business requirements is use of overdraft facility provided by banks. There is a certain limit to the money, which a business can borrow as overdraft against the deposits that the company makes in the bank account. Such overdrafts are taken for shorter duration and interest for such loans is charged on a daily basis. A third way of financing business needs is use of government grants. Such money can be invited only if the purpose of seeking funds complies with the governmental requirements for giving grants. A relevant example could be setting up of a business in a rural area that might invite government grants for promotion of business within the region. A new concept of venture capital funding has come into the scenario of meeting fund requirements for all types of business. Venture capitalists are business houses, who invest their excess money into business plans or growing businesses with a view to benefit from higher returns provided on such loans. Such investment generally goes into small and medium sized business units. Such funds can be sought to meet large expenses, like, buying of plant and machinery, equipment and expensive items of the business, when it is up and running (NFIB, 2009). Another source of finance is the concept of hire-purchase. This funding is for buying of equipments for business operations. These equipments are hired or leased out, instead of being purchased, thereby saving the company from spending large sums, in the present, for buying equipments that can be leased out for smaller amounts; and repayment of the rest can be done in instalments as the business progresses. This also saves a lot of time in seeking funds and avoids major repair expenses (Tirole, 2010). The last and one of the most extensive ways of raising funds is by way of issue of securities, like, equity and preference shares. This gives out company ownership for the provision of funds and shareholders become a part of the profit sharing activity. Debenhams market value and finance needs over the last 3 years The company chosen for analysis in this segment is Debenhams Plc. This is a high fashion retail departmental chain, which was established in UK in 1993. The company owns about 172 stores in UK alone and grosses annual revenue of about £2.23 billion per year, as of 2012. The company is also listed on the London Stock Exchange. Debenhams operates in 26 countries worldwide. The gross profit margin is at 13.59%, while the net profit margin is at 5.6%. Return on equity and assets also appear favourable at 18.20% and 6.06%, respectively. The company has also stated that it is about to expand its global operations by increasing the number of stores to 150 in UK, by the end of five years from this day. The company is similar to Fashionista, in terms of annual revenue and size. Debenhams has a similar revenue flow and owns most of its stores with a view to have greater control over the same. The company has used current debts to the tune of GBP 2.9 million in 2013 from GBP 1.3 million in 2011. This implies that expansion plans for Debenhams have been extensively funded by current and short-term debt funds and have also enabled it to improve its debt position over 2011-2013. The company has not raised any funds by way of further issue of equity capital. The retained earnings have remained negative in 2011 and 2012. Nevertheless, the company has maintained a significant level of retained earnings in the year 2013. This is in an attempt to support huge expansion and renovation plans of company stores, which Debenhams aims to undertake within 2014. Besides that, debt has not been sought for the long-term. This implies that most of the funding comes from retained earnings and profit reinvestment into the business. This is not a healthy sign for a growing company. However, it is expected that Debenhams will take up a huge plan of store renovation, rolling out new stores in the coming years, which would raise the need for additional capital (Debenhamsplc, 2014). Figure 2: The level of Assets and Liabilities for Debenhams Plc. (Source: Ft.com, 2014) Debenhams tried to improve its net debt position through strategic share buyback. Total debt equity for the firm stands at 0.536 and it has been trying to reduce its debt position considerably. The company uses its increased cash flow to finance business needs. The company has invested 133 million in financing investment needs in 2013. Low debt equity ratio might also imply that the company is not using funds to the fullest capacity, which in turn can deter the scope for business expansion. On the other hand, high equity and large number of store ownership indicate that the company has strong fundamentals and asset strength, which can allow it to raise loans. The justification for use of low debt levels is that the market is undergoing a slump, at the present, which does not offer much scope for expansion. The UK economic scenario is quite dull and consumers do not have enough disposable income in their hands to spend on high fashion needs. Additionally, there is a huge unemployment problem within the country, which causes sales to decline even further (Ibisworld, 2013). In such a scenario, the company needs to look outside UK for expanding the scope of business activities and satisfying shareholders. Figure 1: Revenue and Profit growth over the years for Debenhams Plc (Source: Ft.com, 2014) Increase in revenues and profitability has seen little change, over the past three years, as shown in the figure above. It is noted that in present market scenario, cost cutting is the only way to avoid profit warnings (Hellier, 2013). Company profits have observed little growth over the past year. Problems faced due to high costs of manufacturing in China, which is the main manufacturing set-up for Debenhams, has posed a serious challenge to company profitability. Additionally, global sales in the fashion retail chain segment are low. This is primarily because the disposable income available to consumers has reduced. There are not enough jobs being created, leading to widespread unemployment problems (Moon, 2010). Strategic decisions to improve this condition are being made for the purpose of reducing labour cost and shifting manufacturing base to Bangladesh, Vietnam and Cambodia. Justification and Articulation of recommended approach For a medium sized company, like, Fashionista Plc, sources of finance are numerous. It has been stated that the company runs high on equity funds, while relying less on debt funding. The company owns most of its retail outlets, with a large asset base and strength to raise debt funds for the purpose of expansion. The company also maintains a P/E ratio at 18.5, which implies that owners get extremely high returns for every dollar that they have invested within the company. The company is planning to expand its operations by entering into a new segment of clothing. This also calls for an expansion of store count and store capacity, along with production related expenses. It is expected that the market for ‘ladies fast fashion’ shall triple by end of the next five years. Also, the practice of owning most stores is quite expensive, given that the industry trend is to have franchise outlets, so as to make quick expansion. Based on the provided background, it is suggested that the company opts for debt funds, owing to the situation of low debt fund within company portfolio; huge expansion plans; good company worth; and huge scope for expansion (Thetimes100, n.d.B). With good company image and strength in company assets, Fashionista Plc shall not face any problems in sourcing debt funds. Additionally, it is also essential for the company to maintain a good debt equity ratio so as to keep the shareholders satisfied. If the company seeks to expand only by way of equity funding, there shall be dilution of shareholders’ profits. Also, the scope for expansion becomes quite limited by way of equity finance. Debt funds allow the freedom to use funds as per decision of the management and there is least interference from providers of debt funds. Another option available to the company for sourcing funds is by way of using retained earnings, rather than distributing such profits to shareholders in form of dividends. The price earnings ratio is very high and suggests that the shareholders have faith in company operations. The decision to use retained earnings for investment purposes should not invite any retaliation from shareholders because of good market value and position of the company (Damodaran, 2011). Lastly, as a strategic move, the company should promote an increase in its retail base by way of franchising outlets, rather than owning them. This shall reduce cost implications for the purpose of store expansion. In addition to that, franchising is a faster way to grow, compared to establishing company owned stores (Johnsen and Applegate, 2007). Reference List Beattie, V., Goodacre, A. and Thomson, S. J., 2006. Corporate Financing Decisions: UK Survey Evidence. Journal of Business and Accounting, 33(9-10), pp. 1402-34. Damodaran, A., 2011. Applied Corporate Finance. New Jersey: John Wiley and Sons. Debenhamsplc, 2014. Annual Report - 2012. [online] Available at: [Accessed 13 February 2014]. Financial reporting Council, 2009. Going Concern and Liquidity Risk. [pdf] Financial Reporting Council. Available at: < https://www.frc.org.uk/FRC-Documents/FRC/Going-Concern-and-Liquidity-Risk-Guidance-for-Dire.aspx> [Accessed 13 February 2014]. Ft.com, 2014. Debenhams Plc – Key Financials. [online] Available at: [Accessed 13 February 2014]. Gov.uk, n.d. Business Finance Explained. [online] Available at: < https://www.gov.uk/business-finance-explained> [Accessed 13 February 2014]. Hellier, D., 2013. Debenhams demands a little help from its suppliers (again). [online] Available at: [Accessed 13 February 2014]. Ibisworld, 2013. Department Stores in the UK: Market Research Report. [online] Available at: [Accessed 13 February 2014]. Johnsen, A. and Applegate, E., 2007. Cases in Advertising and Marketing Management: Real Situations for Tomorrows Managers. Lanham: Rowman & Littlefield. Moon, H. C., 2010. Global business Strategy – Asian perspective. Singapore: World Scientific. NFIB, 2009. Debt vs. Equity Financing: which is the best way for your business to access capital? [online] Available at: [Accessed 13 February 2014]. Pattani, A., Vera, G. and Wackett, J., 2011. Going Public: UK companies use of capital markets. [pdf] n.p. Available at: [Accessed 13 February 2014]. Ross, S. A., Westerfield, R. W., Jaffe, J. and Kakani, R. K., 2009. Corporate Finance. New Delhi: Tata McGrawHill. Thetimes100. n.d.A Sources of finance. [online] Available at: < http://businesscasestudies.co.uk/business-theory/finance/sources-and-uses-of-finance.html#axzz2tBfV1uwt> [Accessed 13 February 2014]. Thetimes100. n.d.B Investment Decisions. [online] Available at: < http://businesscasestudies.co.uk/business-theory/finance/sources-and-uses-of-finance.html#axzz2tBfV1uwt> [Accessed 13 February 2014]. Tirole, J., 2010. The theory of Corporate Finance. New Jersey: Princeton University Press. Read More