© 2000 John Petroff

To grow companies need capital. Some capital can be generated internally as retained earnings belonging to shareholders if the company has profits and does not distribute them all. The rest must be raised in capital markets or borrowed. Decisions as to what type of capital to seek will be studied in next chapter. Here we raise the issues of what proportions of debt and equity companies should use. And whether companies ought to use debt at all. We answer affirmatively but with a number of limitations. Aggregate fund flows in the United States show that roughly half is equity and half debt, but that includes individuals, financial institutions and governmental agencies. The average proportion for American nonfinancial businesses is actually one third equity and two thirds debt. At a first glance, it seems that 34% or 50% are pretty close and are reasonable proportions all firms could accept. In reality, nothing inspires more divergence of view than what proportion of capital firms ought to have.

Whereas, there is close to general consensus among all points of view on sales, profits, liquidity and even asset breakdown. This is not the case when it comes to the question of whether either equity or debt is more desirable. Each lender prefers to see as little debt as possible. Each shareholder may prefer the firm to use as much leverage as possible, but that is debatable. Management fears borrowing, but can't achieve its goals without it. The sections in this chapter reflect this duality of debt positive and negative aspects. The following sections are covered:

A- Interpretation of numbers in the Liability and Equity portion of the balance sheet

B- Reasons for using debt: financial leverage
C- Financial risk
D- Combination of operating leverage and financial leverage
E- Theoretical optimal debt-equity mix
F- Explaining differences in capital structure

This chapter will build on theoretical justifications for using debt to show that the proportions for most firms is far from 50-50 or one-third-two-thirds. Choosing the wrong proportion can have dire consequences and is a major cause of business failures. In practice, the distinction between debt and equity is increasingly mooted by the variety of financial instruments that companies have available to match their specific financial needs, as will be seen in next chapter. As in previous chapters, before starting the investigation of why debt should be used, we start by looking at the numbers themselves to determine if our analytical work could be derailed by distortions.

See review questions Q-11.1 through Q-11.3.

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