Finance in the Hospitality and Tourism Sector (2024)

Capital Structure

Most of the areas of hospitality and tourism sector of the economy fall within the SME in the economy. One of the major challenges faced by these sectors is how to finance their activity, being largely dependent on the financial institutions particularly the banking sector. However, since the Basel III regulations where the banking sector is expected to scrutinize their lending activity in order to ensure reduction in loan defects, it has greatly impacted the ability of SMEs to access loans both for start – ups and existing businesses.

Capital structure is an important topic in financing businesses across the globe. It started with the Modigliani and Miller (1958) theorem under specific assumptions that the capital structure of a business does not affect the value and the cost of capital. This theory is centred on an assumption of no taxes, no bankruptcy costs and no transaction costs in the economy (Correia, et al., 2015). Corporate capital structure, according to the argument of Myers (1993), is a puzzle; this is because of its inability to provide an answer to a classic question of “how firms should choose their capital structure”. The planning of capital structure involves the consideration of stakeholders’ interest. This means businesses in the hospitality and Tourism industry are expected to plan their capital structure from its inception. Capital structure is a vital management decision that influences both owner’s equity return and market value of shares. It is therefore important for firms to develop an ideal capital structure (Salawu & Agboola, 2008).

The value of a business venture depends on how well its investment and financial decisions are made. Management’s target should be to choose the capital structure that maximises the value of the firm for owners or shareholders. The main aim of management’s capital structure decision is to determine how to allocate its operating cash flow at every period between shareholders and debt holders. Both returns to shareholders and debt holders are costs to the firm. The cost of and the access to finance represent an important dimension in firms and the decisions about capital structure choice, which is essential for firm’s value as well as the stimulation of shareholders’ benefits. The capital structure of a company is said to reflect the debt to equity ratio in the choice of finance. There has been the classification of factors that affect the capital structure of firms which are (a) internal factors that are specific to the firm and (b) external factors that reflect the macroeconomic condition of a specific country.

Developed countries derive knowledge about capital structure formation from data, and different countries have different institutional arrangement especially in the areas of existing market for corporate control, bankruptcy, and tax code as well as the roles of security markets and banks which make it almost impossible to infer that, what determines capital structure in the developed economies can be used to explain what is obtainable in developing countries. This connotes that the vast empirical research of the determinants of capital structure in advanced economies could be limited applicability for financial decision making in developing economies (Pacheca and Tavares, 2017).

A good number of people conducted research on capital structure of tourism and hospitality sector, including Giuseppe (2012) who found that trade credit and trade debt are not relevant to the sector, but loans and mortgages are important medium and long-term financial instruments. He identified the bank as the main provider of adequate source of funds for the sector and suggested it has its shortcomings by penalizing growth opportunities. There are firm stands on the order of preferred financial structure which are as follows: Internal equity/financing, debt and external equity financing. However, only profitable firms can generate the necessary funds to use internal equity or finance. Rapidly growing firms may want to use debt, but lenders are aware of the suboptimal investment effort of shareholders and try to extract wealth from them by increasing interest paid on loans forcing fast growing firms not to use debt. This type of financing however is specific to hotel firms, while restaurant firms exhibit different behaviour regarding capital structure.

The restaurant industry is a diverse one. Restaurant firms have a reputation of excessive risk. Eating and drinking establishments report a very high number of business failures. Firms that suffer from lack of cashflow are forced to find sources of funding outside the firm preferably debt. According to Upneja and Dalbor (2012), restaurant firms on average, strike a balance between short - term and long-term debt. Although short-term debt is considered a necessity in the industry, obtaining this type of financing can be difficult, given the risky nature of the restaurant business. The research found that older firms use more of long-term debt. The findings were specifically for publicly listed restaurant firms in a developed country. The difference between short-term and long-term debt is that the former comprises any debt due within one accounting year, while the latter is a financial obligation that lasts more than one year.

With the in-depth discussion about capital structure, it is certain that the hospitality and tourism sector does not follow a specific theory, which means they vary in their capital structure strategies. It has been discovered that most of the businesses in the hospitality and tourism industry depend on debt financing. This is largely because of perceived high risk, it is therefore a big challenge for businesses in the sector to secure both short and long-term financing.

The whole idea about finance is to determine what to invest in, how to get the capital to invest, and how to manage the investment. Finance is therefore identifying necessary resources, determining how to get funding and managing the assets that are bought with the funds.

  • What to invest?

There are two main types of investments -- long-term and short-term investments. Long-term investments involve investing in infrastructure such as land, building, machines, equipment etc. while short-term investments are the use of funds to buy inventories, pay staff wages, funds for advertising and marketing activities.

  • Where to get money?

The decision about where to source for funds could be to borrow from creditors such as banks, to ask shareholders for more funds or to use internally generated profits.

  • How to manage the money borrowed?

This is an issue of timing, budgets, interfacing with suppliers and staff.

As an expert in finance with a focus on capital structure and its implications in various industries, including hospitality and tourism, I have a deep understanding of the theories, challenges, and practical applications involved in financing businesses.

Firstly, let's delve into the concept of capital structure, which refers to the mix of debt and equity used by a company to finance its operations and growth. It's a crucial aspect of financial management as it directly impacts a firm's cost of capital, value, and risk.

The article mentions the Modigliani and Miller (1958) theorem, which lays the foundation for capital structure theory by positing that, under certain assumptions (e.g., no taxes, no bankruptcy costs, no transaction costs), the capital structure of a firm does not affect its value or the cost of capital. This theoretical framework has been extensively studied and forms the basis for further discussions on capital structure.

However, empirical research has shown that in real-world scenarios, factors such as taxes, bankruptcy costs, and asymmetric information influence firms' capital structure decisions. For instance, Myers (1993) highlights the complexity of capital structure decisions, emphasizing the need for firms to consider stakeholder interests and financial constraints when determining their optimal capital structure.

In the context of the hospitality and tourism industry, accessing financing, particularly from traditional sources like banks, has become increasingly challenging due to regulatory changes such as the Basel III regulations. These regulations have led financial institutions to tighten their lending criteria, affecting the ability of small and medium enterprises (SMEs) in the sector to secure funding for both start-ups and ongoing operations.

The article also discusses the factors influencing capital structure decisions, including internal factors specific to the firm (e.g., profitability, asset structure) and external factors related to the macroeconomic environment (e.g., interest rates, economic conditions). Understanding these factors is essential for businesses in the hospitality and tourism industry to devise effective capital structure strategies that align with their financial goals and constraints.

Furthermore, the article highlights the role of debt financing in the industry, driven by perceived high risk and the need for businesses to secure both short-term and long-term funding. It discusses the challenges faced by restaurant firms in particular, which often resort to a mix of short-term and long-term debt to finance their operations due to the risky nature of the business.

In addition to capital structure, the article touches upon broader financial management principles relevant to businesses, such as identifying investment opportunities (long-term vs. short-term investments), sourcing funds (borrowing from creditors, seeking shareholder contributions, using internal profits), and managing borrowed funds effectively (budgeting, timing, supplier and staff management).

Overall, the article provides a comprehensive overview of capital structure considerations in the hospitality and tourism industry, underscoring the importance of financial management decisions in driving business success and sustainability.

Finance in the Hospitality and Tourism Sector (2024)

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