Equity v Debt – Sustainable Financing Options
Uganda is ranked as the world’s most entrepreneurial country according to the Global Entrepreneurial Monitor (GEM),2014. Consequently, Uganda is home to many companies especially Small and Medium Sized Enterprises (SMEs). Such enterprises need adequate financing in order to run effectively or expand their portfolio. Companies raise finance and capital in different ways – through equity; by allotting and selling shares, or by listing on the public market through an Initial Public Offering (IPO). Companies also raise capital through debt by accessing loan facilities which may enable expansion and help them meet their costs. Many companies especially in Uganda are heavily in debt, this has almost become part of the norm. This article will discuss the merits of debt financing against equity financing and will outline which of the two is more sustainable financing option.
Kampala – Uganda’s Capital, has one of the highest numbers of SME’s owing to entrepreneur spirit of Ugandans. Photo Credit: Matopress
Borrowing helps companies access capital which can be crucial in expanding production. For instance, a tea company may set out to increase its volume of processed tea, but it may not have the financial resources to buy more machines or produce from farmers to achieve this goal. With a feasible business expansion plan, such a tea company may access a loan from a financial institution. This aids its intended expansion, increased supplies and, in the long run, its profits. In some circumstances, businesses are able to repay their loans and achieve their expansion goals, however, in other circumstances (most), companies are unable to do so. The Daily Monitor in 2017 reported that over 66 companies sought a government bail out because they had accumulated too much debt that threatened their ability to stay afloat. This leads to the fundamental question? Is debt a sustainable model for financing businesses?
It is undeniable that debt finance may help a company expand, however, there are legal consequences when a company’s debts become due. These usually have an impact on the day to day running of the business. For instance, the imminent risk of having all the company’s assets liquated to pay off their debts, high interest rates especially in the Uganda’s financial services market, and debt covenants which may restrict the company’s ability to undertake different business leads. Debt financing will ultimately affect the company’s ability to pay dividends to its shareholders.
Debts might be sustainable but only until all the aggregate sum of debts combined do not exceed the business’ assets. At that stage, the only options left are winding up a company, liquidating its assets in order to pay back the creditors and going into administration. The most famous Ugandan example is Uganda Telecom Limited (UTL). UTL was placed under administration and is now administered by Senior Counsel, Ruth Sebatindira, the former President of the Uganda Law Society. All this was part of a chain of events which culminated when UTL went to the High Court in 2017 to block a petition seeking to wind it up over a debt of Uganda Shillings 709Billion. UTL’s winding up simultaneously led to the laying off of hundreds of employees, to lower costs of operation.
Ultimately, prevention is better than cure. What if companies started tapping more into the potential of equity financing? This is where companies allot and sell off shares or even an asset such as land or machinery in order to raise money. This is more flexible than borrowing as it does not come with chains of high interest rests, unreasonable debt covenants and risks of insolvency
Companies and enterprises have begun to tap into the equity finance as opposed to debt financing as per statistics in the Economic Policy Research Centre (EPRC), according to the World Bank enterprise survey data by 2013, 49% of firms in Uganda used retained earnings to finance themselves and about only 28% used borrowing. Although other equity financing options like an IPO may be costly due to overregulation, equity financing is the better approach for companies.
Instead of debt, that inevitably exposes one to the risk of insolvency, equity finance is a better business friendly solution to financial challenges.