Debt or Equity, which one should you look at in 2021?

financial analysis

By Andrew Boyle, CEO of LGB & Co.

In each edition of Business Leader Magazine, we look at the subject of funding and for this edition we examine the role of debt and equity can play in growing a business and the issue of the need to increasing diversity in funding decisions.

The consequence of the 2008-2009 financial crash for corporates was a liquidity crisis. Huge capital losses in the banking sector and a breakdown in the interbank lending market caused banks to withdraw facilities from even blue-chip corporate customers.

In contrast, the pandemic has triggered an immediate supply of liquidity through the furlough scheme, CBILs lending and the Bounce-Back Loan Scheme (BBLS). Instead, companies face a health crisis in which they are physically prevented from engaging with their customers. This has challenged many well-established business models and has accelerated the demise of others that have already been undermined by new technologies that reduce physical interaction.

Some companies are looking to raise funds to stay afloat, while others need additional working capital to seize new opportunities. All need to think carefully about how they present themselves to funders and investors. Is debt appropriate? If so, what type of debt? Or is equity financing the better option?

Plenty of funds available

Besides the government initiatives mentioned above, there is money available to support fundraising. Private equity and debt funds have been busy raising money in the last few years and are still seeking opportunities. And, since Covid-19 has disrupted deal flow, many now have a backlog of investments to make.

Banks are far better capitalised compared to the 2008 crisis, and innovative challenger banks are also now available that simply did not exist 12 years ago. Additionally, private and institutional investors are on the hunt for yield.

Of course, the sector in which a company operates is highly relevant to their funding prospects. Companies in certain sectors have prospered, while others in sectors such as hospitality, travel and leisure sectors, for example, have faced an existential crisis.

Debt still an option as a bridge to revenues

Fundamentally, debt is a bridge to expected cash flows. Companies facing short term business interruptions can therefore consider debt as a financing option. Nevertheless, these companies should ensure they have an appropriate repayment profile for their businesses.

Short term options could be using an overdraft or invoice discounting, while longer term options might be a term loan of four to five years.

Companies can also turn to medium term note (MTN) programmes, which LGB manages. These establish common documentation for multiple issues of securities. The key feature of such programmes is access to a diverse group of lenders. Companies can develop relationships with loan note holders, who make independent buying decisions.

Equity finance can help companies with reduced revenues that need to restructure

If Covid-19 has caused a fundamental, adverse change in a company’s business model, it will require more than a bridge to expected cash flows. In this case, equity capital, rather than debt, would be appropriate. Equity capital can provide the resources required to restructure a business.

Given that many companies have suffered a fall in revenues, the key factor in discussions with investors and lenders are balance sheet ratios. It can be important to get these back in line through an injection of equity. Once the outlook has improved, there may well then be an opportunity to take on debt further down the line.

If a company has an equity shortfall it should be proactive, whether this entails a radical rewriting of business plans or creating new initiatives. For example, it could concentrate its operations on areas that offer the highest return on capital, or it could restructure, sell parts of the business, or collaborate with other firms.