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How an Business should restructure its debt

By: Jonathan Wernick, Corporate Finance Transactor, and Tsakane Maringa, Corporate Finance Analyst, Sasfin Capital

Balance sheet restructuring is the term used when a company reorganises its capital structure or mixture of debt and equity. During its lifecycle, a company may decide to restructure the way in which it funds its operations. More directly, should a company increase the amount of debt it carries relative to its equity or vice versa? 

How best to reconcile debt vs equity?

An important question for a business owner to ask is “What is the optimal mixture of debt and equity for their business?” The answer in short, is that it very much depends on the size, nature and operating structures of the business – in this space, these is no one-size-fits-all approach. For example, in South Africa, companies find themselves facing a rising interest rate environment and may be tempted to reduce the amount of debt they currently have on their balance sheets.  

It may seem simple enough that reducing debt to avoid higher interest payments would be the logical way to go, but it is not so simple.

The benefits of debt reduction

One positive aspect of reducing debt is that it would provide some relief to a company in the short and medium-term. With debt, there is an obligation to repay both the capital portion and interest portion of the loan. As interest rates continue to rise, it would be more difficult for a company to service its debt and in some cases a company may run the risk of defaulting on its loan repayments. Another positive aspect is that debt reduction could provide have positive growth impact on the company. For example, increased debt payments could put a strain on a company that is trying to grow as more cash is being used to service the debt.

Before reducing debt, one needs to consider how it would be reduced. If debt were to be reduced, cash that would be used to repay the debt would either have to come from an internal source, such as excess cash or the sale of assets, and if not available, then from an external source. If repaid using internal sources, this could have a negative impact on future growth prospects as the excess cash and assets sold to repay the debt could no longer be deployed to generate returns for the company.

 

If an external source were to provide the cash to repay the debt, this cash received from an external source would take the form of an equity investment. This could result in a dilution in shareholding for existing shareholders.

As can be seen, reducing a company’s debt burden to avoid rising interest rates is not quite as simple as it seems and needs to be considered carefully before any decisions are made.