The repayments on debt are agreed with the lender and are usually interest-rate related.

Holders of equity, on the other hand, are owners of the company whose reward is a share of the profits (a dividend). These 'investors' are taking a risk, and so they would expect their reward to be at least equal to the returns on other alternative forms of investment.

Equity

Since the holders of equity are not guaranteed any payment, businesses may feel that they can suspend or reduce the payment of dividends when times are tight.

The risk of overlooking the claims of shareholders, however, is that the owners of the equities will start to sell their shares, the price of which will slide.

As a result, there will be a fall in the value of the company which will raise the prospect of an unwelcome takeover.

Fixing an appropriate dividend is often a difficult judgement. Directors have to take into account not only the performance of their own company but also what ‘the market’ expects.

Investing institutions rather than individuals hold most shares, and if these organisations fail to get the return they want, they will sell and switch into better-performing shares.

Debt

Relying on bank borrowing (debt) rather than equity is not a risk-free alternative.

The more debt a company has, the more it is vulnerable when interest rates start to rise. While in difficult times, dividend payments could be reduced, down to nothing if necessary, companies have to meet their repayments on debt.

Failure to do so could lead in extreme circumstances to a business being wound up. Even if it does not come to this, a highly indebted company will generally have to pay more out of its earnings in a period of rising interest rates, constraining its activities in other areas.

Quite often, rising interest rates will also have the effect of squeezing the spending power of a company’s customers and so they are exposed on both the cost and income sides of their accounts.

To assess the financial strength and performance of a company, and to compare companies of different sizes and in different industries as investment prospects, external analysts have created a series of ratios based on a company's annual accounts.

In terms of external funding, the balance between debt and equity is known as gearing, and a highly-geared company is one that has an above-average dependence on borrowing.

The net borrowing requirement is the net change in a company's financial position. In reality, companies acquire financial assets (such as bank deposits, other company shares etc) while taking on extra financial liabilities (external finance through bank borrowing, issue of equity etc). The difference between these two flows is equal to the difference between investment and internally generated funds (see Chart 15.4.)

Source: ONS

Until the mid 1990s, the acquisition of financial assets and the increase in external finance were low and stable. But this changed in the second half of the decade as companies sharply increased their mergers and acquisition activity.

Companies to turn to capital markets

Such activity was especially high in 2000 when the figures were also inflated by borrowing to pay for the third generation of telecommunications licenses which were auctioned by the Government during the year. Merger and acquisition activity since 2000 has reverted to its late 1990s level.

In terms of the composition of external finance, the trend in the 1990s was for companies to turn increasingly to capital markets for their funding needs rather than use the banking system (see Chart 15.5).

This led to a relative decline in the importance of bank borrowing by private non-financial corporations (PNFCs) but an increased reliance on marketable debt and equity finance.

Return to bank finance

From 2000 on, however, the position has reversed. The periodic fragility of capital markets, generally made companies less prepared to raise money through the issue of marketable paper. Instead they turned to banks to provide finance, and falling interest rates made this a more attractive option.

The only exception was in 2007 and early 2008 when the strength of the stock markets was sufficient to persuade companies to return to raising equity finance on top of a further sharp rise in borrowing. But this was short lived and, as recession took hold in 2008, there was less recourse to both banks and stock markets.

Capital issues

The bulk of capital issues (ie. issues of ordinary shares, preference shares and debt instruments) in the five years to 2007 was by service companies.

The energy and water industries, post-privatisation, have been active in renewing infrastructure and so, although accounting for only around 3% GDP, they have been responsible for a much larger proportion of capital market fund raising.

In 2008 and early 2009, however, the manufacturing sector changed from running down its dependency on the stock market to becoming a net issuer of debt whilst the service sector did the opposite.

Table 15.2: Net Capital issuance by selected industries

Within capital issues, the issue of debt (bonds and commercial paper) has become much more important in recent years. One of the reasons for this shift in funding will have been the fall in long-term interest rates in the latter part of the decade.

Money markets increasingly saw the UK as being a low-inflation economy, a perception which was enhanced by the Government's decision to take the control of interest rates out of the political arena and give it to the Bank of England.

In consequence the inflation premium on long term rates once demanded by the market was removed and cheaper long-term borrowing gave companies a greater choice in how they fund investment and acquisitions. A need to restructure balance sheets saw a huge jump in the issue of bonds in the second half of 2008 and into 2009.

Table 15.3: Sterling Capital issues by Instrument