Profitability and Debt Ratios
The pecking order theory explains the inverse relationship between profitability and debt ratios:
- Firms prefer internal financing.
- They adapt their target dividend payout ratios to their investment opportunities, while trying to avoid sudden changes in dividends.
- Sticky dividend policies, plus unpredictable fluctuations in profits and investment opportunities, mean that internally generated cash flow is sometimes more than capital expenditures and at other times less. If it is more, the firm pays off the debt or invests in marketable securities. If it is less, the firm first draws down its cash balance or sells its marketable securities, rather than reduce dividends.
- If external financing is required, firms issue the safest security first. That is, they start with debt, then possibly hybrid securities such as convertible bonds, then perhaps equity as a last resort. In addition, issue costs are least for internal funds, low for debt and highest for equity. There is also the negative signaling to the stock market associated with issuing equity, positive signaling associated with debt.
Read more about this topic: Pecking Order Theory
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