Owners and managers of businesses always have the option of financing a business by way of either debt or equity. For any business, there is usually an optimal debt-to-equity ratio that best fulfills the goals of its owners and managers and which depends on a number of factors.

There are numerous advantages to financing through debt. Debt has the advantage of generally being tax deductible, although tax regimes in some countries do set a limit on the amount of debt that is deductible, and debt financing has the advantage of avoiding dilution of equity ownership. The cost of debt financing is therefore lower than the cost of equity.

However, the big disadvantage of debt financing is that it increases the level of risk, that is to say that there is a higher risk of default. Moreover, as the level of debt increases in a company, the cost of such debt also tends to increase so as to compensate for the additional risk.

There are also a number of cyclical factors that may have an impact on the debt-to-equity ratio. The expected debt-to-equity ratio varies depending on whether markets are bullish or bearish, the trends in the particular sector of the economy, or indeed whether a company is in an early development phase or at maturity.

During the last economic boom, most business owners would have preferred a higher mix of debt-to-equity as debt was readily available, interest rates were lower, companies had more accurate earnings forecasts, and earnings tended to rise over time. Expansion could be financed via debt, while existing equity owners remained in control and interest was tax deductible.

However, during the current recession, earnings are much more difficult to predict – companies often have trouble forecasting the coming quarter, let alone for the year – and debt is less readily available as a result of the much more conservative lending policies the banks are adopting. Interest rates like Euribor or Libor have decreased by several percentage points, but the amounts charged above these inter-bank rates have generally increased by anywhere from 100 to 400 basis points for most companies – meaning that the real cost of debt financing, after adjustment for inflation, has generally increased.

The word "deleveraging" has been used often during the current recession. The dynamics described above often force companies to substitute equity for debt. However, equity has also become more difficult and costly to find compared to 18 months ago. Despite this, beefing up the balance sheet with a healthy dose of equity is an option that the majority of business owners and managers should be considering today.

In addition to the option of equity injection, hybrid instruments that contain features of both debt and equity may also strengthen a company’s financial position. Two common hybrid instruments are preferred shares – which have an obligation to pay a certain dividend rate – and convertible debt – where the lender may be willing to accept a lower interest rate in exchange for having the option to convert the debt into equity at a later date.

Hybrid instruments typically have a level of risk that is higher than debt but lower than equity and therefore the cost of financing also lies somewhere between the cost of debt and the cost of equity.

A strong balance sheet can be an even bigger source of strength and competitiveness in a recession than during a boom. It is no accident that even strong banks, such as HSBC, are raising equity, not because they are under-capitalised, but to take advantage of opportunities in the marketplace. Equity may also be viewed as a financial cushion, something that could help companies weather a deepening recession in the event that the much-touted recovery does not occur as soon as expected.

*Les Nemethy is the chief executive officer of Euro-Phoenix Financial Advisors Ltd. (www.europhoenix.com), a Central European corporate finance company focused on mergers and acquisitions. Marcel Nicula is a Senior Analyst with Euro-Phoenix in Romania.