The Level of Gearing or Improving the Maturity Structure of Debt - Essay Example

?Discuss the theoretical and practical factors that influence the level of gearing and the maturity structure of debt in large quoted companies Introduction The criteria on which investment decisions on large firms are based are likely to be differentiated under the influence of a series of factors. Normally, the economic conditions in the local market influence the ability of a large firm to respond to its daily financial obligations without seek for financing. Large firms can seek for financing through their investors. However, in periods of strong financial turbulences, like the current one, the potentials of investors to respond to their firm’s financial needs is limited. In this context, borrowing has become a common method of financing for large firms, a fact that has influenced the status of these organizations as investment units. Indeed, large firms with high financial obligations, due to borrowing, are likely to be avoided by potential investors. The latter will examine each firm’s financial characteristics before deciding to invest on a particular firm. Current paper focuses on the examination of two important issues related to the debt in large firms: the factors that influence the level of gearing and the maturity structure of debt in large quoted companies are presented and critically discussed. The literature published in the specific subject is used in order to show the various implications of the above issues. It is revealed that the level of gearing and the maturity structure of debt in large quoted firms are likely to be depended on a series of factors which are not standardized. Rather the type and the power of these factors is depended on the characteristics and the rules of the local market, as influenced by the global economic trends. 2. Theoretical and practical factors that influence the level of gearing in large quoted companies Gearing is a term used in order to reflect ‘the proportion of the firm’s total assets owned by long and short – term creditors’ (Chisholm 2002, p.147). In other words, gearing shows the ability of the firm to repay its creditors, even through its assets in case of lack of cash. In the context of gearing, two are the most important factors that are expected to influence the ability of the firm to pay its creditors: the level of debt and the company’s assets. In modern firms, the level of gearing seems to be differentiated in accordance with the size of the firms. The above phenomenon can be explained as follows: in small firms, borrowing is the most common form of financing – aiming to avoid offering part of the firm’s management in order to be financed. In this context, small firms are expected to have high level of gearing. In large quoted firms, where there is no problem with giving part of the firm’s equity to third persons (the investors) for securing the necessary financing, the level of gearing is low (Walton 2000). There is also the opposite view. More specifically, Atrill et al. (2008, p.231) notes that large quoted firms are expected to have higher gearing compared to the small firms. The above view is based on ‘a report of the Bank of England regarding the financing of small businesses’ (Atrill et al. 2008, p.231). This report reveals that the level of borrowing of small firms is lower compared to that of the large firms, probably because the financing needs of large firms in the particular market cannot be covered by the capital of the shareholders (Atrill et al. 2008). Under these terms, the level of gearing in small and large firms cannot be considered as standardized. Rather, it would be depended on the conditions and the characteristics of the local market – in the context of which the borrowing schemes available to the large firms may be more attractive compared to those offered to small firms, a fact that would minimize the level of gearing in small firms and maximize the level of gearing in large firms. In accordance with Chisholm (2002), normally, the level of debt of firms is lower from their equity (assets), otherwise the rights of the creditors would be in risk. In other words, gearing is used in order to show the level at which the equity of the firm can guarantee the repayment of its debt. From this point of view, gearing highly affects investment decisions in quoted companies, indicating the level at which a particular investment is secured, i.e. efficiently backed by assets in case that the debt of the firm involved becomes due. The level of gearing in each organization will be depended on its involvement in specific business decisions. For example, when a business seeks for debt, the level of gearing should be differentiated in accordance with the level of the firm’s cash flows. If the business has regular cash flows then the level of gearing would be high; on the contrary in businesses with volatile (uncertain) cash flows, the level of gearing would be low, indicating the difficulty of the firm to respond to its financial obligations (Helliar 2005). Furthermore, the amount of the cash flow should be also important for its level of gearing; however, at this point the level of the required debt would be used to define whether the level of the cash flow is of decisive importance for the firm’s level of gearing. More specifically, when the cash flow is both regular and high, then the level of gearing would be high, showing that the firm could effectively cover the needs of a high debt (Helliar 2005). However, with a regular but low cash flow, the firm would not have much chance to cover its financial needs, thus, a high debt would be avoided and a low debt should be preferred, being able to be repaid on time. In the last case, the low level of gearing would be used to show that the firm could face difficulties regarding its financial obligations. The above issues are of particular value for large quoted companies, where the needs for financing are high and where the ability of each of these firms to respond to its financial obligations need to be carefully estimated prior of the engagement of the firm to a specific financing scheme. On the other hand, Ryan (1995) notes that the level of gearing can be related to the weighted average cost of capital (WACC) in the following way: a relatively high level of gearing can result to the reduction of the WACC, but only up to a point. It is noted that ‘the high level of gearing is also related to high level of risk’ (Ryan 1995, p.131). This means that in large firms with high gearing, investors would have to accept a high risk regarding their investment; because of this perspective, ‘some of these investors may ask for compensation’ (Ryan 1995, p.131). In this case, the WACC would be increased; in this context, the initial limitation of the WACC because of the high level of gearing would be of no value, since, at the next level, the WACC would have to be increased (Ryan 1995). The relationship between gearing and WACC is also emphasized in the study of McLaney (2009). In the above study it is made clear that the relationship between gearing and WACC leads to another relationship, the one between the gearing and the claims of investors for compensation. Again, the specific relationship is based on the fact that the high level of gearing indicates the high risk – referring to the risk resulted from a firm’s daily operations, including its investment decisions. Under these terms, McLaney (2009) notes that in quoted firms with high gearing investors are expected to ask for a compensation for their involvement in an investment of high risk (as the shares of the firm with high gearing can be characterized). Furthermore, ‘the provision of higher returns to investors, as a compensation for high risk’ (McLaney 2009, p.299) would affect the internal rate of return ratio (IRR) of the firm influencing the investment decisions in regard to the specific organization. At this point, the following issue should be highlighted: as already discussed above, quoted firms are not highly depended on common financing schemes mostly because their needs are covered by their investors. In this way, the level of gearing in these firms, where external debt is low, is likely to be low (Arnold 2008). Furthermore, the chance that the firm will have to respond to the claims of its investors for high returns is low. However, in periods of financial crisis, like the current one, the dependency of quoted firms on external financing may be increased. As a result, the level of gearing will be also increased followed by the claims of investors for higher returns. On the other hand, large quoted firms with high external debt – derived from borrowing schemes – can reduce their gearing level, having the chance to seek for additional financing. This target can be achieved by issuing shares, an activity which decreases the level of gearing and increases a large firm’s potentials to seek for additional borrowing (Pike et al. 2006, p.465). The view emphasizing on the relationship between gearing and the value of the firm is opposed by the theory of Modigliani and Miller; the above theorists do not accept any role of the gearing on business value (or else, the WACC). Instead, they note that ‘the value of a firm is solely dependent on the business performance and the business risk’ (Ryan 1995, p.131). In this context, the relationship between the level of gearing and the value of a firm would be differently evaluated – in accordance with the theory accepted. Coyle (2004) emphasizes on the importance of gearing for quoted companies. It is noted that in firms of this size, gearing risk is used in order to indicate ‘the risks of high borrowing in relation to the amount of shareholders’ capital in the business’ (Coyle 2004, p.10). The above view highlights an important role of gearing in quoted companies: in these firms the potential investors could use the level of gearing for deciding the risk and the potential value of their investment (Pike et al. 2006). From this point of view, the level of gearing is necessarily related to the value of the firm since it can influence the decisions of investors in regard to a particular quoted company. 3. The maturity structure of debt in large quoted companies The factors that mostly affect the debt maturity structure in large quoted firms would be related primarily to the economic environment in which each firm operates. At the next level, the conditions in the internal organizational environment would be also related to the maturity structure of debt in firms of this size. In order to understand the role of these factors it would be necessary to refer to the characteristics of the term ‘maturity structure of debt’ as used by theorists and investors worldwide. The term ‘maturity date’ refers to the date that a debt is due; therefore the term ‘maturity structure of debt’ refers to the structure of the debt (instalments, interest) up to its maturity. In this context, a flat maturity structure of debt would indicate the existence of no changes in interests or taxes over the period of the debt (Dornbusch et al. 1990, p.149). The maturity structure of debt is likely to affect the following two elements of debt: a) the costs and b) the risk. In the study of Guscina (2008) it is explained that the maturity structure of debt is of high importance in case of government debt. In the debts of this type, particular importance seems to have’ the monetary stability’ (Guscina 2008, p.16). Other factors which can influence the maturity structure of government debt are the following ones: ‘a) the level of inflation, b) the political risk, c) the financial development and d) the level of interest rates’ (Guscina 2008, p.16). The above factors could also affect the maturity structure of debt of large quoted companies under the terms that these firms are key parts of the local market and they highly contribute to the performance of the local economy. The options available to governments regarding the optimal maturity structure of government debt would be also important for understanding the similar options for investors and CEOs in large quoted companies. In accordance with Dornbusch et al. (1990) the maturity structure of debt would be chosen by governors in order to ensure that the government, which will follow, will not adopt different policies, in regard to the particular debt, but they keep the initial agreement. In other words, the maturity structure of debt ensures the lack of changes on the relevant contractual agreement protecting more effectively the interests of the parties. At this point, the following comment should be made: the value of the maturity structure of debt may be questioned in case that the initial agreement was not quite successful, for the interests of one of the parties, or whether the conditions, in which the agreement was made have been changed. Then, the review of the specific agreement would be necessary, a process that could face delays in case that a maturity structure of debt is involved. In general, it is assumed that the choice of the maturity structure of the debt in large quoted firms cannot be standardized; rather, executives in these firms should decide on the elements and the characteristics of maturity structure of the company’s debt taking into consideration the following factors: a) the expansion of the recession (referring to current market conditions), i.e. the conditions in the global market (De la Torry et al. 2007), b) the performance of the firm as also of its competitors, in order to understand the potentials of the firm to keep its profitability as standard levels, c) the local market trends – in terms of the prospects of each particular industry (Brigham et al. 2007), d) the performance of the national economy, which influences the buying power of customers and thus the firm’s profitability (Branch et al. 2007), e) certain economic indicators, such as the level of inflation, the level of interest rates and the exchange prices (Branch et al. 2007) and f) the resources available for the support of organizational plans, as this fact is related to the achievement of organizational goals and the level of a firm’s profitability. 4. Conclusion In accordance with the issues discussed above, large firms are not highly differentiated from small firms regarding the level of exposure to market risks. Moreover, in large quoted firms the criteria and the terms for get involved in financing schemes of various types are not sufficiently checked in advance. The use of various methods for lowering the level of gearing or improving the maturity structure of debt, does not have particular value in limiting the level of risk in large quoted firms. In any case, the level of gearing and the maturity structure of capital are used in large quoted companies as tools for improving the business value, a fact that also benefits the shareholder value. From this point of view, gearing and the structure of capital in large quoted firms can have two different dimensions: as tools for attracting investment and as tools for securing the wealth of investors. References Arnold, G. (2008) Corporate financial management. Essex: Pearson Education Atrill, P., McLaney, E. (2008) Financial accounting for decision makers. Essex: Pearson Education Branch, B., Ray, H. (2007) Bankruptcy Investing - How to Profit from Distressed Companies. Washington: Beard Books Brigham, E., Daves, P. (2007) Intermediate Financial Management. Belmont: Cengage Learning Chisholm, A. (2002) An introduction to capital markets: products, strategies, participants. West Sussex: John Wiley and Sons Coyle, B. (2004) Risk awareness and corporate governance. Canterbury: Lessons Professional Publishing De la Torry, A., Schumkler, S. (2007) Emerging capital markets and globalisation: the Latin American experience. Washington: World Bank Publications Dornbusch, R., Draghi, M. (1990) Public debt management: theory and history. Cambridge: Cambridge University Press Guscina, A. (2008) Impact of Macroeconomic, Political, and Institutional Factors on the Structure of Government Debt in Emerging Market Countries. Washington: International Monetary Fund Helliar, C. (2005) Interest Rate Risk Management. Oxford: Elsevier McLaney, E. (2009) Business finance: theory and practice. Essex: Pearson Education Pike, R., Neale, B. (2006) Corporate finance and investment: decisions & strategies. Essex: Pearson Education Ryan, B. (1995) Strategic Accounting for Management. Belmont: Cengage Learning Walton, P. (2000) Financial statement analysis: an international perspective. Belmont: Cengage Learning Read More