Debt in the firms balance sheets - Essay Example

?Strategic Financial Management Introduction Ordinary shares can be simply defined as shares which are not preferred shares and which do not offer fixed dividend amounts. As Nevin (1973, p. 322) states, an ordinary share directly indicates equity ownership in a company and it entitles the owner to voting rights in various crucial affairs of the company in proportion to their percentage of shareholding. Ordinary shareholders are entitled to receive dividends on their investment only if anything left after all liabilities are paid. In contrast, debt is an obligation owed by one party (debtor) to another party (creditor). In case of debts, lenders have no rights on the firm’s operations and are unable to take part in determining major strategic issues (Bureau of the Public Debt, 2010). It is observed that different organisations maintain different levels of debt and equity in their balance sheets. This paper will critically appraise root causes of varying levels of debt in the firm’s balance sheets. Debts and debt levels Organisations and businesses across the world use debt to finance their day to day operations and other particular projects. The levels of debt are fundamental macroeconomic data and it they largely vary from company to company. Generally, levels and flows of public debt are given central importance while levels and flows of private debt are not considered as a major cause of concern (OU Guide, n.d). Stocks and flows are two important tools of debt measuring. Stocks are levels of debt and they have units of currency whereas flows change in debt levels and have units of currency/time. All credit is debt and it is created by lenders who agree to lend money for the exchange of adequate future returns. Lundgren (n.d) reflects that the amount of money lent is considered to be the asset of the creditor while it becomes the liability of the debtor. Debt is often issued along with a specific repayment plan; and the debt maturity time or period of repayment may range from a few days to 50 years or longer. According to the maturity period, debt is classified into three categories such as short term, medium term, and long term debt. In order to accurately calculate total debt of a business, it is necessary to take off-balance sheet debt into account as all debt items may not show up on the balance sheet. As Shearn (2011, p. 116) states, these debt items may include lease obligations, warranties, purchase contracts, unfunded pension liabilities and any other contractual obligation. However, this type of debt is generally disclosed in the footnotes attached to the financial statements. White, Sondhi & Fried (2006, p. 323) indicates that the liability amount shown on the balance sheet may not always represent total cash flow required to meet the debt. Business houses only record the present value of the future cash flow. To illustrate, if a firm borrows $1,000 at an interest rate of 12%, total amount payable at the end of that period becomes $1,120. However, the balance sheet will only represent the present value of the future payment or $1,000. Factors affecting levels of debt As Crane, Knoop, and Pettigrew (1977) point out, different firms have varying strategies in maintaining their debt levels and this strategic differences cause debt level variances in firms’ balance sheets. A firm considers an array of factors before framing its debt level strategies. In the words of Long and Ravenscraft (1993), no firm would allow its debt level to grow beyond its repayment capacity as this condition may adversely affect the feasibility and market repute of the business. More precisely, a firm’s debt level heavily depends on its borrowing policies. “Tthe capacity to borrow depends on several factors such as profitability, stability, relative size, asset competition, and the industry position of a business” (Shearn, 2011, p.115). Hart (1995, p. 142) argues that profitability plays a pivotal role in determining the debt level of a business house. General trends indicate that level of debt will be in an elevated position in the balance sheet of highly profitable companies as compared to the debt level of less profitable organisations. It is evident that leading firms would always tend to keep huge amounts with them so as to explore and utilise new opportunities, and hence they raise large funds from various sources. In contrast, less profitable organisations generally do not keep huge debts in order to ensure long term business sustainability. In the view of Rochon and Polemarchakis (2006), stable companies may keep higher levels of debt as they can clearly predict what their returns would be. On the other hand, instable organisations may be uncertain about their future and therefore they may not be willing to take immense debt risks with their business. According to Kealhofer (2003), it is obvious that large corporations may have easy access to a range of potential financial sources as their credibility and repaying capacity are high. In contrast, small firms may possess limited financial sources and hence they cannot raise too much funds even if they are willing to take excessive risk. Likewise, industry position of a business can have a significant effect on its level of debt. It is clear that leading industry players enjoy a high market reputation and hence their market demand may continue to grow regardless of their debt levels. At the same time, shareholders and other investors would not allow huge debts for companies which have low goodwill. The debt level of firms also depends upon external factors including credit market conditions and trends. Under a tough credit environment, banks and other financial institutions may not be ready to allow huge volume of credit; and hence, they impose more lending restrictions such as lower debt to income ratios. In contrast, financial institutions are more likely to lend money under an easy credit environment. Consequently, they liberalise their credit policies by raising debt to income ratios with intent to expand the volume of credit applicants. “The amount of total debt a business can put on its balance sheet depends on the amount and distribution of cash flows a business generates as well as the value of the assets securing the debt” (Shearn, 2011, p.115). For instance, cash flows are steady in case of a utility business and therefore it can easily manage relatively huge amounts of debt on its balance sheet. In contrast, companies having more cyclical cash flow pattern cannot manage high levels of debt on their balance sheet as they need to take more time to pay back their debts when their cash flows vary with the business cycle. In addition, a firm’s expansion policies also notably affect its debt levels. To illustrate, firms desiring high economic growth tend to borrow large amounts of money whereas firms expecting a stable income are more likely to cut down their borrowings. Commencement of new investment projects would contribute to an increased level of debt in a firm’s balance sheet (National Bank of Poland, 2006). Even a huge multinational corporation often would not have adequate reserve funds to finance new investment projects; hence, companies are forced to depend on bank loans or other means of credit facilities to make new investments. Likewise, an increase in the employment level may directly lead to a proportionate increase in an organisation’s debt level (National Bank of Poland, 2006). When a firm improves its employment level, it will be badly in need for large volume of funds for financing various phases such as recruitment, training, and retention programmes. Hence, naturally, the firm is forced to depend upon credit, and this situation causes an increase of debt level in its balance sheet. Firms’ levels of debt may also vary in accordance with credit policies of central banks. According to Mulraj (2002), it is observed that a drop in interest rates leads to an increase in debt levels since companies are more likely to utilise credit facilities under such a situation (Times of India). According to Faccio, Lang, and Young (2001), corporate governance policies of a company determine its level of debt in the balance sheet. Motiram (2009) says that unforeseen contingencies may sometimes force firms to raise additional funds to overcome the resulted difficulties. Under such circumstances, firms will not have an option other than borrowing from credit lending institutions. Hence, such situations may increase a firm’s debt levels. In addition, adverse changes in business trends would also influence level of debt in balance sheets. When the market condition becomes worse, it may negatively affect firms’ sales volume and hence they cannot repay debts on time. Naturally, this situation would increase the debt levels. Finally, increased market competition can also have great influence on the debt levels of a firm. While operating under a highly competitive market environment, a firm is forced to raise more working capital to effectively confront with rivals. Such a situation may cause the firm to vary its debt levels at the end of the accounting period. Capital Structures Firms’ capital structures also play a significant role in determining the level of debt in its balance sheet. There are several theories of capital structure including net income theory of capital structure, net operating income theory of capital structure, traditional theory of capital structure, and Modigliani and Miller theory. According to Khan and Jain (2005, p. 94), under the net income theory of capital structure, a firm maintains higher level of debt than equity share capital. In contrast, the net operating income theory of capital structure holds the view that market value of the firm must be the same at every level of capital structure. Referring to the view of Ghosh, Cai, and Osberg (2008), the traditional theory of capital structure is the mix of the first two theories. According to this theory, the debt level of a firm varies in relation to the progress of the business (ibid). In contrast to the traditional theory, the Modigliani and Miller approach argues that there is no relationship between cost of capital and capital structure (ibid). This theory also states that a change in debt level will not affect cost of capital. Conclusion From the above discussion, it is clear that a firm’s level of debt in its balance sheet may largely depend on a number of external as well as internal market factors. Profitability, stability, size, and market reputation are some of the major elements determining the debt levels of a firm. In addition, availability of bank loans is another major factor that causes varying levels of debt in firms’ balance sheet. Firms’ capital structure also has a crucial role in determining their balance sheet debt level. Finally, commencement of new investment projects, increase in the employment level, and varying central bank policies also influence a firm’s debt levels. References Bureau of the Public Debt 2010, ‘Have you ever borrowed money?’, Treasury Direct, Viewed 11 January 2012, Crane, DB, Knoop, F & Pettigrew, W 1977, ‘An application of management science to bank borrowing strategies’, Interfaces, vol.8, no.1, pp.70-81. Faccio, M, Lang, LHP & Young, L 2001, ‘Debt and corporate governance’, pp.1-39, Viewed 11 January 2012, Ghosh, A, Cai, F & Obserg, RH 2008, ‘The determinants of capital structure’, Capital Structure and Firm Performance, Transaction Publishers, New Jersey. Hart, O 1995, Firms, Contracts and Financial Structure, Oxford University Press, New York. 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