Doing business has always been challenging. Since the beginning, companies have faced financial distress, hindering their ability to service debt. In such situations, they resort to various strategies to stay afloat. One such strategy is a debt-equity swap, which allows companies to reduce their debt burden by converting debt into equity. Let us understand debt-equity swap in detail and see its benefits and implications.
What is a debt-equity swap?
A debt-equity swap is a financial transaction mostly undertaken by business organisations. Using it, a company exchanges some of its outstanding debt obligations for ownership or equity in the company. In simple words, through a debt-equity swap, companies offer their lenders or creditors equity shares or preference shares instead of the amount owed to them.
Let us understand this concept better through a hypothetical example:
The scenario
- A company, XYZ Ltd., is facing financial difficulties due to a high level of debt.
- XYZ Ltd. owes Rs. 50 Crore to its lenders, primarily in the form of:
- Bank loans and
- Bonds
- However, the company's operations are struggling.
- It is becoming challenging for XYZ Ltd. to meet its debt obligations.
- To address this situation, XYZ Ltd. decides to pursue a debt-equity swap with its creditors.
The negotiations
- XYZ Ltd. enters into negotiations with its lenders.
- The company proposes the idea of converting a portion of its outstanding debt into equity shares.
The agreement
- After discussions, XYZ Ltd. and its creditors agree to a debt-equity swap.
- It is decided that Rs. 20 Crore of the total debt owed by XYZ Ltd. will be converted into equity.
The conversion
- The agreed-upon Rs. 20 Crore of debt is converted into equity shares at the current market price (CMP).
- Assume the CMP of each share of XYZ Ltd. is Rs. 100.
- XYZ Ltd. issues 20 lakh (Rs. 20 Crore/ Rs. 100 per share) new shares to its lenders.
How does a debt-equity swap impact the capital structure of a company?
Usually, a debt-equity swap has a significant impact on the capital structure of a company. Let us look at the three major impacts:
Impact I: Reduction in debt
- A debt-equity swap's primary effect is the debt reduction on the company's balance sheet.
- By converting a portion of its debt into equity, the company decreases its total debt obligations.
- This debt reduction:
- Improves the company's financial health
- Decreases the risk of default.
Impact II: Increase in equity
- As debt is converted into equity, the equity portion of the company's capital structure increases.
- This increased equity enhances a company's financial flexibility and resilience.
Impact III: Change in financial ratios
- Due to a debt-equity swap, the capital structure of a company gets altered.
- This alteration leads to changes in various financial ratios.
- For example,
- The debt-to-equity ratio decreases due to the:
- Reduction in debt and
- Increase in equity
Let us continue with the example of XYZ Ltd. and better understand these impacts:
The debt reduction
- After the debt-equity swap, XYZ Ltd. sees a significant reduction in its debt burden.
- The Rs. 20 Crore of debt converted into equity has lowered the company's total debt from Rs. 50 Crore to Rs. 30 Crore.
- This can improve the company's financial health, as now it has less debt to service.
The increased equity
- Under the debt-equity swap, XYZ Ltd. has issued 20 lakh new shares to its lenders.
- This issuance has increased the equity portion of XYZ Ltd.'s capital structure.
- The company’s lenders now collectively own 20 lakh shares.
- They now have a vested interest in the company's performance.
- If XYZ Ltd. succeeds and its share value increases, the lenders stand to benefit from capital appreciation.
How is a debt-equity swap initiated?
The process of a debt-equity swap can be:
- Voluntarily initiated by the company or
- Are a part of the bankruptcy proceedings or restructuring plan
A real-life case study
In the recently concluded resolution plan of SREI Infrastructure Finance (SIFL), creditors were given a portion of the equity in the company as part of the resolution plan. After several negotiations with the lenders, a final resolution plan was approved. It granted all consenting creditors equity shares in SIFL amounting to 20% of their admitted claim.
How do debt-equity swaps impact existing shareholders?
When a company issues fresh equity shares in a debt-equity swap, it reduces the ownership percentage held by current shareholders. This means that the percentage of the company owned by existing shareholders decreases. This dilution happens because the total number of shares outstanding increases.
For example:
- Say a company has 50 Crore outstanding shares.
- It issues an additional 10 Crore shares to creditors through a debt-equity swap.
- In this case, existing shareholders' ownership will be diluted proportionally.
This dilution reduces the earnings per share (EPS) of the company. Due to an increase in the number of shares outstanding, the company's net income is now spread across a larger number of shares.
Continuing the above example,
- Say the company earns Rs. 200 Crore as profits during the year.
- Before the swap, its EPS was Rs. 4 per share (Rs. 200 Crore/50 Crore shares).
- However, after the swap, the EPS reduced at the same earnings level.
- Now, the company's EPS is Rs. 3.33 per share (Rs. 200 Crore/60 Crore shares).
This dilution is concerning for existing shareholders, as lower EPS:
- Signals reduced earnings potential and
- Lead to a decline in the company's stock price.
Conclusion
Debt-equity swaps are strategic business decisions. Often, companies facing financial distress opt for this swap to convert their existing debt obligations into equity shares. This process can be initiated by a company voluntarily or as part of the ongoing bankruptcy proceedings.
Furthermore, a debt-equity swap dilutes the ownership stakes of existing shareholders and reduces the EPS. Despite this, such an arrangement remains a viable strategy for companies, as it helps them manage debt and improve financial performance.
Do you wish to gain more knowledge on the equity segment? Learn what is trading on equity and return on equity (ROE) today.
