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 2^nd 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.

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.