Image of debt and equity balance

There are a number of businesses, particularly small and mid-size enterprises (SMEs) in Ghana that do not consider the impact their capital structure has on their financial performance, market value and shareholders’ wealth. Most often, SMEs in Ghana mainly focus on getting capital to fund their projects or activities without really thinking through the impact (positive or negative) the mechanism used to raise that capital has on their business therefore causing them future problems.

Made up of debt and equity, capital structure is the utmost business decisions that determine the overall cost of capital and, eventually, the market value of a company. In my view, there are three types of capital structures, thus, all debt no equity, all equity no debt and a proportion of debt and equity. Having to juggle between long-term and short-term interest of a company in terms of the ability to retain earnings; satisfy shareholders; maximize value and improve the company’s credit worthiness shows the gargantuan effect capital structure has on a company’s financial performance and shareholders wealth.

In an ideal market, it is imperative for companies to be levered, that is, combine both debt and equity. Deciding whether to be levered or unlevered is something that is vital for business managers to make as both debt and equity have their advantages and disadvantages. For instance, debt financing allows owners to retain ownership and control of their business. It also helps to reduce tax obligation because interest payments are tax deductible expense in most jurisdictions. But debt has repayment obligations which might negatively affect a company’s credit rating when the company defaults with its debt repayment. Equity financing on the other hand will most likely lead to less control for business owners. Also there is a strong notion that equity financing is costly comparatively to debt financing in the long term.

The quest to determine the best capital structure in order to increase firm value lies within several factors including size of company, profitability, risk, liquidity, market size, cost of research and development, real assets and others. This affirms that not getting capital structure right might be detrimental to a company’s future.

Over the years, various approaches such as The Net Income Approach, Net Operating Income Approach, Traditional Approach, Modigliani & Miller Approach, Pecking Order Theory, Trade-off Theory and Agency Cost, have been developed to throw more light on the various dynamics of capital structure. For instance, the Modigliani-Miller theory states that the market value of a firm does not depend on its capital structure but rather on forecasted upcoming revenue in an ideal market assuming there are no taxes. The Pecking Order Theory emphasizes that due to asymmetric information, firms ought to opt for financing using internal funding sources such as retained earnings as their first option and then use debt financing as their second option before equity financing as last option. There is another viewpoint that professes that it is cheaper to fund investments with retained earnings than with debt or equity because of the cost of capital. Also, to reduce information failure and other factors, some companies mostly grow or execute projects with internal funding because it is believed that a company’s management are well informed about their own operations than outsiders such as lenders and investors, who most often also set rules of engagement for the company.

The value of a business increases when the business is able to decrease Weighted Average Cost of Capital (combination of all sources of a company’s capital—including common stock, preferred stock, bonds, and any other long-term debt) leading to optimal capital structure. It is therefore imperative for businesses that want to increase profitability to pay key attention to their capital structure. This is because when a business adopts the right capital structure – ratio of debt and equity – that maximizes return on assets and enables higher profit to be attained and retained, the business can increase its profitability thereby increasing shareholders wealth. In conclusion, to position a company to be financially superior thereby maximizing its value and shareholders wealth, there must be an excellent ratio of debt and equity unique to that particular company. It is therefore significant for SMEs in Ghana to focus on this area and plan accordingly to future-proof their businesses.

About the writer: King Adawu Wellington is a business strategist with expertise in executing projects and helping companies achieve their goals in diverse industries.

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