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The Capital Structure of Chinese Companies

The Capital Structure of Chinese Companies

 

 

 

 

Introduction

The capital structure adopted by a firm is a critical determinant on its attractiveness to investors.  According to Stice and Stice (2012), capital structure refers to the combination of different sources of financing employed by a firm (Baker & Martin 2011).  There are different sources of finance that firms can adopt in establishing its capital structure. For example, businesses can raise funds by issuing equities and debt instruments in the capital market. Alternatively, businesses can source capital from financial institutions such as banks.  According to Baker and Martin (2011), the sources of capital adopted by a firm influences the degree of risk faced. Therefore, it is imperative for firms’ managers to ensure that their businesses are characterised by a capital structure that poses the least degree of risk (Periasamy 2009).  Thus, firms should seek to optimise their capital structure in order to maximise their firm’s value. Developments in financial markets have provided businesses an alternative source of capital such as from issuance of bonds and equities as opposed to depending on loan from financial institutions. This aspect has contributed to significant reduction in the degree of risk faced by businesses.  This paper evaluates the capital structure of Chinese companies. The analysis focuses on the extent to which Chinese companies have developed an effective capital structure.

Sources of finance

Debt finance

According to Choudhry (2001) a company’s capital structure is comprised of two main components that include debt and equity finance. Debt finance refers entails sourcing financial capital from creditors. Debt finance can be either long-term or short term debt. Short term debt may entail short-term bank loans.  Bank loan may also constitute a companies’ source of long term debt. Debt finance further relates to issuance of bonds.

Equity sources of finance

Ryan (2007) asserts that equity financing entails obtaining funds from issuance of shares stocks or retaining a company’s earnings or profit in a company’s equity.  Unlike debt finance, equity financing involves issuing shareholders a certain proportion of a company’s ownership. Equity can be sourced from issuing two main types of stocks that include ordinary and preference shares. The cost of raising capital from issuance of stocks such as through an initial public offering is substantially high (Ryan 2007).

 

Capital structure theories

Developing an effective capital structure constitutes an essential element in organisation’s quest to achieve sustainability. Bogan, Johnson and Mhlanga (2007) assert that a firm’s capital structure is positively correlated with an organisation’s resilience to market changes.  Therefore, it is imperative for businesses to appreciate the importance of developing an optimal capital structure by mixing both debt and equity sources of finance. Companies financing decisions can explain by different theories that include the trade-off and the pecking order theory.

Trade-off theory

 The trade-off theory is based on evaluating the costs and benefits of debt financing (Baker & Martin 2011). Therefore, in making financing decision, business managers evaluate the extent to which reliance on debt finance will increase the risk faced. This aspect is supported by Hommel et al. (2012) who affirm that debt finance increases an organisations risk for encountering financial distress and bankruptcy. Application of the trade-off theory contributes to development of an optimal capital structure. This arises from the fact that an organisation is able to trade-off the costs associated with borrowing against the benefits. By optimising its capital structure, a firm is able to maximise the value of its assets and investments. In applying the trade-off theory, a firm benchmarks the debt-to-equity at a particular point and progressively replaces debt sources of finance for equity sources or equity for debt until it succeeds in optimising its capital structure (Hommel et al. 2012).

Pecking-order theory

 According to Kronwald (2010), the pecking order theory proposes that ‘companies follow the pecking order in their financing decisions’ (p.2). Thus, businesses prioritize to source capital form internal funds as opposed to equity due to existence of information asymmetry. Alternatively, Ingelheim (2010) asserts that the pecking order theory stipulates that businesses resort to external source of financing if the internal sources of funds are insufficient. Moreover, the theory proposes that in the event that internal sources are inadequate, businesses will resort to straight debt, convertible debt and external equity in that order.

In making capital structure decisions, it is imperative for businesses to follow the financing hierarchy order as stipulated by the pecking order theory. The rationale of following the pecking order theory is underlined by the fact that it provides companies’ managers’ adequate flexibility and control on a company’s financing. According to Damodaran (2011), over reliance on external sources of financing reduces an organisation’s flexibility with reference to accessing credit finance in the future. This aspect underlines the importance of relying on internal sources of equity financing such as using retained earnings in financing businesses’ operations.

Evaluation of capital structure in Chinese companies 

Companies in China are focused on optimising their capital structure by establishing a balance on their dependence on equity and debt finance.  This aspect is illustrated by the increased dependence on both debt and equity finance amongst companies in different sectors.  Thus, the companies have entrenched a complex capital structure (Damodaran 2011). A study conducted in 2013 by McKinsey & Company, a renowned financial services consultant firm, shows that China has experienced a remarkable increase in dependence on both debt and equity finance.  According to the study, the value of domestic financial assets viz. bond, loans, and equities amongst Chinese companies was estimated to be $ 17.4 trillion making China the 2nd largest financial market (McKinsey & Company 2013).  The change in the capital structure amongst Chinese companies between 2007 and 2012 is illustrated in table 1 and graph 1 below.

Type of financing

2007

2008

2009

2010

2011

2012

Loans

4.4

5

6.8

8.2

9.5

10.2

Corporate bonds

0.1

0.2

0.4

0.6

0.7

0.7

Equities

7.2

3

5.4

5

3.4

3.6

Table 1

Graph 1

Source: (McKinsey & Company 2013)

Loans

Table 1 and graph 1 shows a significant increase in Chinese companies’ reliance on different source of finance.  From graph 1, it is evident that bank loan account for the largest source of finance amongst companies. The amount of loans issued increased from a low of $4.4 trillion in 2007 to a high of $10.2 trillion in 2011, which represents a 131% increase.  According to McKinsey & Company (2013), approximately 85% of the total bank loans in China were issued to corporations.

Non-financial corporate bond issuance

            Non financial firms in China have increased their issuance of bonds in an effort to boost their capital structure. This trend is evidenced by the increase in the volume of corporate issuance with reference to different types of debt instruments such as commercial paper, enterprise bonds, medium term notes and corporate bonds. Graph 2 below illustrates the volume of commercial paper issues in the Chinese bond market from 2008 to 2012.  

Graph 2

Source: (McKinsey & Company 2013)

According to graph 2, China experienced a significnt increase in the volume of commercial paper issued by companies in the bond market. This increase in the volume of debt instruments is further supported by graph 1, which shows that Chinese companies are increasingly sourcing funds by issuing corporate bonds. The volume of corporate bonds issued increased from $ 0.1 trillion in 2007 to $0.7 trillion in 2012 (McKinsey & Company 2013). One of the factors that have contributed to increase in the volume of corporate bond issuance amongst Chinese companies entails implementation of the economic stimulus package.  The economic stimulus package, which targeted the construction industry and small and medium sized enterprises, has greatly contributed as a source of long term financing to corporate entities.

Equity

Equity capital constitutes a fundamental source of capital for Chinese companies. Unlike bank loans and corporate bonds which have increased significantly, the issuance of equities by Chinese companies has been characterised by considerable fluctuations as illustrated by graph 1 and table 1. For example, between 2007 and 2008, the volume of equities issued declined from $7.2 trillion to $ 3 trillion. Despite the increase experienced in 2009, the issuance of equities remained significantly low in 2010 and 2011. The fluctuation in the volume of shares issues may have resulted from reduction in investor confidence on stability of companies as a result of the global economic recession (McKinsey & Company 2013).

In spite of fluctuation in companies’ reliance on equity market for finance, it is projected that equity capital will constitute one of the major sources of finance for Chinese companies. The emerging economies such as China are characterised by a significant improvement in operations within the financial markets. According to Ingelheim (2010), equity market capitalisation within the capital markets in emerging economies remains considerably low at 22% of the total global equity market capitalisation. Conversely, the market for sovereign and corporate bonds account for only 14% of the total market capitalisation in the global market. This indicates that there is a high potential for growth within the capital market in the emerging economies (Manulife Asset Management 2015). China ranks amongst the emerging economies characterised by a vibrant capital market.  One of the factors that have contributed to growth in the country’s capital market entails liberalisation of the capital account. It is projected that China’s equity market will overtake some of the developed economies such as the United Kingdom and Japan hence becoming the 2nd largest equity market globally by 2030 (Manulife Asset Management 2015). The growth in equity market underlines the increased utilisation of capital market by companies in sourcing for long term finance.

Conclusion

            The above analysis underlines the fact that a company’s capital structure is positively correlated to an organisation’s pursuit for long term sustainability.  This arises from the fact that the mix of different sources of finance, which constitutes a firm’s capital structure, determines the degree of risks faced. For example, overreliance on debt finance increases a firm’s risk of bankruptcy due to the high cost of capital. On the other hand reliance on equity finance significantly reduces the risk of bankruptcy because the cost of capital associated with sourcing finance from equity finances is substantially low. In making decisions on capital structure, it imperative for business managers to formulate the right mix between equity and debt is integrated. To achieve this goal, business managers should consider entrenching two main theories viz. the trade-off theory and pecking-order theory.

 The analysis conducted shows that Chinese companies are committed at optimising their capital structure. This finding is underlined by the companies’ adoption of debt and equity sources of financing. However, the proportion of debt to equity sources of financing amongst the Chinese companies varies significantly.  Loans and equities constitute a major component of capital structure amongst the Chinese companies.  Moreover, Chinese companies are also increasing their depending on bonds as a debt source of financing. By integrating these sources of financing, the Chinese companies have been able to develop an effective capital structure by ensuring that they establish an effective balance between the costs and benefits of alternative sources of finance.

One of the factors that have contributed to increase in reliance on debt and equity sources of financing amongst the Chinese companies entail increase in the rate of market development due to economic liberalisation. For example, development of the country’s financial markets has provided companies an opportunity to adjust their capital structure through issuance of equity and debt instruments.  By entrenching debt and equity finance, Chinese companies will succeed in strengthening their sustainability. Optimising the capital structure will enable Chinese companies to significantly reduce the risk associated with reliance on one source of financing.  

Recommendations

In their quest to strengthen their capital structure, it is imperative for Chinese companies to take into consideration the following aspect.

  1. Chinese companies’ managers should conduct a comprehensive cost-benefit analysis in determining the sources of capital to obtain funds from. The cost benefit analysis will aid in minimising the risk associated with an ineffective capital structure.
  2. Chinese companies should consider expanding their debt source of financing by issuing corporate bonds targeting foreign investors.
  3. Chinese companies should progressively evaluate the effectiveness of their capital structure in enhancing attainment of long term sustainability. The analysis should focus on evaluating the extent to which the inherent capital mix structure contributes to reduction in the company’s risk.

 

 

References

Baker, K & Martin, G 2011, Capital structure and corporate financing decisions; theory and evidence, John Wiley & Sons, New York.     

Bogan, V, Johnson, W & Mhlanga, N 2007, Does capital structure affect the financial sustainability of microfinance institutions? [Online]. Available at: <http://www.cid.harvard.edu/neudc07/docs/neudc07_poster_bogan.pdf> (Accessed December 8, 2016)

Choudhry, M 2001, Capital market instruments; analysis and valuation, Financial Times Prentice Hall, Harlow.

Damodaran, A 2011, Applied corporate finance, John Wiley & Sons, Hoboken, NJ.

Hommel, U, Fabich, M, Schellenberg, E & Fimkom, L 2012, The strategic CFO; creating value in a dynamic market environment, Springer Science & Business Media.

Ingelheim, M 2010, Influential literature analysis on the pecking order theory; an investigation, GRIN Verlag GmbH, Munchen.

Kronwald, C 2010, Credit rating and the impact on capital structure, GRIN Verlag, Munchen.

Manulife Asset Management: The changing shape of capital markets in emerging economies 2015. [Online]. Available at: <http://www.manulifeam.com/Research-and-Insights/Market-Views-And-Insights/The-changing-shape-of-capital-markets-in-emerging-economies/ > (Accessed December 7, 2016)

McKinsey & Company: China’s rising stature in global finance 2013. [Online]. Available at: <http://www.mckinsey.com/global-themes/china/chinas-rising-stature-in-global-finance> (Accessed December 7, 2016)

Periasamy, P 2009, Financial management, Tata McGraw-Hill, New Delhi.

 Ryan, B 2007, Corporate finance and valuation, Thomson Learning, London.

 

Stice, E & Stice, J 2012, Intermediate accounting, Cengage Learning, Mason, OH. 

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