To owe or not to owe?

To owe or not to owe?

My parents always told me never to owe money to anyone. ’’To be bound to someone only leads to disaster’’ they said. But on what extent is that true- when talking about companies’ debt-? Well, on this blog the advantages and disadvantages of blogs will be presented. Furthermore, we will take a closer look on MacDonald’s balance sheet and argue whether debt brings should bring exuberance to their stakeholders.

Capital structure defines both the yield for the shareholders and the chances for survival during recession. Capital structure is a combination of equity capital-money gathered from issuing shares- and debt capital-cash inflows from issuing bonds, or other liabilities.

What is the correct balance thought?

On one hand, having low cost of debt equals to reduced risk, greater ability to withstand emergencies such as volatility and recession, allowing greater manoeuvre in the market. On the other hand, it is argued that borrowing money for investments can provide ever-increasing income from interest. Added to this, debt has a tremendous advantage compared to equity. In order to be more precise, enterprises get a tax relief on debt as the interest –in contrast with equity financing- is subtracted before the levy is calculated. Moreover, we should not ignore the fact that in case of bankruptcy, the debtholders receive their fees prior to the shareholders. Lastly, leveraging can span the gap between the ultimate lenders and the borrower. Gearing up with debt can allow the whole financial system to grow since it provides the necessary resources, while creating jobs, to the businesses. Nevertheless, since the economic crisis companies don’t seek a high level of leverage, as the want to have huge piles of cash as reserves. Thus, the past few years governments struggle to reach their financial benchmarks.

So is it accurate to say that companies should rely only on debt? Of course not!

Leveraging merely with debt has some drawbacks that can lead to financial distress. This actually means that the short term income cash flows are not adequate to pay off the short term liabilities. In addition, there are also agency costs which occur from the fact that stakeholders do not actually manage the company.

So we can understand that companies have to find the optimum balance between debt and equity. For McDonald’s debt has almost doubled over the past four years, reaching 26 billion dollars. It is prevalent that most investors will see this number as a warning sign, especially if you take into account the debt to equity ratio which is 109.28%. Nevertheless, if we take a closer look at the numbers we will see that only 77 million dollars are the operational-short term costs-.In addition, this rise in the debt was derived from the managers decision to increase dividend and share repurchase to ‘’reflect the Board and management’s confidence in McDonald’s future. Lastly, we must point out that the restaurant industry is characterized as stable. Thus, McDonald’s to gearing with levels of debt is justified.

To conclude, it is widely accepted that the whole financial system is compared with a living organism. It is always changing and evolving. Changes in the regulation can cause abrupt changes in the optimum balance between capital debt and equity. For example, if Trump’s law- concerning the removal of the companies’ right to deduct their interest expenses from their taxable income- is put forward that could cause a huge distortion as highly-indebted companies are likely to go bust more quickly. So it is important for the enterprises to always try to keep track of their environment and adjust their balance sheets accordingly.

Until next time stay safe.