How to finance manufactories?

Many manu­fac­to­ries in Germany are wondering whether they should better finance them­selves with equity or debt money. However, this ques­tion cannot be answered unequiv­o­cally because both financing options have advan­tages and disad­van­tages and depend on the finan­cial struc­ture of the company.

The financing struc­ture of an enter­prise becomes partic­u­larly rele­vant in the course of granting loans and ratings, since among other things the equity ratio and the debt-equity ratio flow as a quan­ti­ta­tive indi­cator into the clas­si­fi­ca­tion of the cred­it­wor­thi­ness. Banks used quan­ti­ta­tive and qual­i­ta­tive factors to assess the future viability of the company. Key balance sheet figures, such as the equity ratio, are included as quan­ti­ta­tive factors, while market devel­op­ments, account manage­ment, company manage­ment, etc. have an effect on the rating grade as qual­i­ta­tive criteria.

On average, German medium-sized manu­fac­to­ries have an equity ratio of 28.6 %. This figure is just below the general assump­tion that German compa­nies finance them­selves with almost 1/3 equity and 2/3 debt. In the course of invest­ment financing, approx. 52% equity, 30% bank loans, 12% subsi­dies and 6% other (equity and mezza­nine capital) are used.

 

Equity- and debt capital

The fact that the share of equity capital is around 1/3, but that approx. 52% of the invest­ment sum is financed by equity capital, raises the ques­tion of whether equity capital and the more favourable form of financing are involved or whether it has become increas­ingly diffi­cult to obtain bank loans.

In 2018, the share of successful credit nego­ti­a­tions fell by 10 percentage points to 57%. This suggests that banks may have become more restric­tive in lending and conse­quently fewer compa­nies are lending. Nego­ti­a­tions between compa­nies and banks are partly based on rating grades and thus also on key figures such as the equity ratio. If, for example, the equity ratio is too low, banks some­times refuse loans because the default risk is too high or demand a higher lending rate. For entre­pre­neurs, this raises the ques­tion of whether to exploit leverage effects or opti­mise ratings.

 

Diagram: Weighting of finan­cial Struc­tures

The leverage effect refers to the possi­bility that the return on equity will increase if more debt capital is used instead of equity capital. At the same time, the reduc­tion in equity results in a lower equity ratio and a higher debt ratio while debt capital remains unchanged. A higher debt ratio can have a serious impact on the rating and thus on the lending rate, as banks take into account the finan­cial struc­ture of a company, among other things.

It is there­fore impor­tant for entre­pre­neurs to weigh up whether the improve­ment in return on equity or the increase in interest rates for debt capital is more impor­tant. Since in most compa­nies the lever­aged portion of the capital is greater than the self-financed portion, it is in the interest of the entre­pre­neur to keep the loan interest rate as low as possible with increasing leverage. This is possible thanks to an improved equity ratio.

The posi­tive effect of a high equity ratio on the rating grade can be gener­ated by several direct and indi­rect measures to increase the equity ratio and thus opti­mize the rating.

Reducing the balance sheet total, for example by reducing inven­to­ries or using factoring with unchanged equity, indi­rectly improves the equity ratio. It should be noted, however, that these measures should make economic sense and should not be aimed solely at manip­u­lating the equity ratio.

 

Graph: Weighting of finan­cial Struc­ture

Direct measures to strengthen the equity ratio include profit reten­tion, a with­drawal and distri­b­u­tion freeze, further capital contri­bu­tions by share­holders, and differ­en­ti­ated partic­i­pa­tion systems. It should be noted that the entre­pre­neur should care­fully consider whether an opti­miza­tion of the rating grade or the return on equity is advan­ta­geous for him.

Since March 2019, the Master Council has set up a working group to work on the opti­mi­sa­tion of financing struc­tures specif­i­cally for manu­fac­to­ries in order to combine measures for various manu­fac­tory clus­ters.

More Information
Contact Person at Meisterrat:
Dr. Boris Karcher
karcher@meisterrat.de