NATURE OF INDUSTRY
The nature of industry is one of the most important elements in determining the financial leverage a firm can carry safely without any risk of bankruptcy. If an industry’s are subject to wide fluctuations, over a business the firm should have a low degree of leverage. Such firms will already have a high operating leverage. In case both are high, the risk of the firm as determined by the combined leverage (the product of operating leverage financial leverage) would become unduly high. Is the firms with high debt ratios belong industries such as refrigeration, televisions, machine tools and capital equipment manufacture run the risk of not being able to meet the required payments in lean years which would financial distress. Clearly such firms should have a more conservative capital structure and less on debt. On the other hand, industries dealing with non-durable consumer goods (food) or inexpensive items (paper clips, match boxes) or with items in habitual use (cigarettes) or products which have an inelastic demand are not likely to be subject to wide fluctuations. Such industries can afford to have higher debt proportions in capital structure as in lean rs they do not run the risk of being unable to meet their commitments.
Judging industry by its competitive nature, it may be inferred that those industries which have not competition among themselves should have a relatively greater proportion of equity than b1. For example, in the garment industry much of the competition is based on style. The styles unpredictable and transitory the profits also fluctuate accordingly. Therefore, such firms is overemphasis equity over debt because of the excessive risk of not being able to meet on borrowed funds. It’s the other extreme, there are public utility undertakings involved the production of electricity, It as, water transportation services or telephone services, which are alliterative from industrious competition. Their sales arc more stable and predictable. There as such companies can afford to use more debt.
The stage of the life cycle of the industry has also a crucial bearing in assigning relative hostage to various sources of raising finance. If the industry is in its infancy, the probability of rate of mortality would be high. Therefore, more emphasis needs to be placed on equity. The firm would do well to avoid seeking funds from senior securities which require fixed management. At such a stage, risk ourselves the attractions of financial leverage. When the industry reached maturity and is passing through the period of rapid growth, the firm should pay initial attention to maneuverability to assure that as it grows it obtains funds when needed and acceptable terms. If the outlook is for a long-term decline in business, the firm should build a plan which allows for easy contraction in the sources of the funds used. For this purpose, firm can have call provision in the case of senior securities.