Wednesday, 27 May 2009

All debt and no equity

Sometimes, the obvious questions are never asked.

Why, for example, are UK firms so dependent on debt financing? Why don't firms raise funds through issuing equity instead?

The chart above suggests that the amount of new equity financing remains surprisingly low. Those pink peaks in the chart above are largely accounted by near insolvent UK banks who tapped equity markets last summer. Take the banks out of the equity issuance numbers and there is virtually nothing left.

Corporate debt issuance is far more important. The chart above covers just bond issuance. However, the volumes of new debt are multiples of funds raised through equity issuance. If we add in bank loans, the point becomes even stronger.

The reason lies with incentives. If a firm issues new equity, then the share price will fall. Since bonuses are usually linked to share price performance, managers have a strong incentive to avoid issuing new shares.

However, in the long run, high debt levels weakens balance sheets. More debt today, means higher interest payments in the future. However, thinking about the future isn't a big concern for today's managers.


RF said...

The incentives to accumulate debt is the root of this crisis. Great charts BTW.

Anonymous said...

Very interesting post thank you for sharing.