It is becoming increasingly fashionable for Irish industrial businesses to refinance their Irish debt with US loan notes. With longer maturity dates and less invasive covenants on offer, the move makes sense.

But when companies attempt to justify this action with the blanket comment that this form of finance is cheaper than shareholder finance, they are on a sticky wicket. Certainly, raising new equity dilutes earnings per share. But in terms of cash flow for the companies, it does not. Substituting debt with equity enhances cash flow, at least in the early years. The US loan notes arranged by Heiton Holdings, the builders merchants and Atlantic DIY group, last week, indicate how much lost cash flow is involved. They raised $25 million (£16.6 million) at a fixed rate of 7.14 per cent. Heiton said the rate equates to the average it paid on the debt being replaced, so there will be no change in cash flow terms. It has also claimed that the costs (legal, for example) are not material.

It could have raised the same amount from its shareholders in a one for four rights issue at, say, 144p per share (compared with the last quoted price of 185p). The servicing cost, in the form of a dividend payment, would be less than 3 per cent. Even if dividends were raised by a fifth, the cost would still be a low 3.1 per cent. That compares with a net cost of around 5 per cent on the loan notes. The difference in the servicing is almost 2 per cent. The saving to Heiton would have been over £300,000, in the first year. As the dividends increase over the years, and as the rate on the notes is fixed with no currency translation risk (the dollars were converted to pounds), the cash flow benefits would decline over the years.

Nevertheless, assuming a 20 per cent growth in dividends per annum, it would be 2001 before the servicing cost (in the form of dividends) of the new equity would equate to the cost of servicing the loan notes. In the meantime, those "savings" could have been used to enhance the business. Using equity instead of debt also reduces gearing. However, banks are increasingly using interest cover as a much more useful, and more relevant tool, in judging a company's ability to service debt. A number of other companies have also substituted part of their existing debt for US loan notes. Of course, raising funds through the shareholders (or new investors) dilutes earnings because more shares are in issue. In Heiton's case, the earnings represented by the "savings" on the new equity would only amount to a nominal 2p. This is a far cry from the adjusted earnings of 12.3p generated by Heiton, indicating the earnings dilution involved. Heiton has strongly contended that the cost of equity is more expensive and quoted 12 per cent as the cost. This, according to Heiton, comprises 6 per cent for the forgone interest, 5 per cent for the risk premium (equity being more risky than deposits), and 1 per cent for Heiton. Raising funds from shareholders has, of course, the disadvantage that shareholders have to put up extra funds. But companies are less well off in cash flow terms - cash flow that can be used to enhance the value of the companies. So are companies becoming slaves to propping up earnings per share, the yardstick invariably used for judging a company's performance? The answer is that some are. A simple exercise gives the price/earnings ratio (p/e) by which companies can be easily judged against each other. While earnings per share can indicate the performance of a company, and provide an indication of a company's ability to pay dividends, often it does not. Some companies, such as CRH, use cash flow per share, which is a very useful ratio and should be used more often. Cash flow is much lower for companies with large cash balances, making it essential for them to invest the cash in expanding their own enterprises or in takeovers. Lyons Irish Holdings, for example, has cash of £54.5 million, accounting for an unsustainable 93 per cent of net assets. Importantly, those cash assets only generate 32 per cent of the profits. The new battle cry of publicly quoted companies is the need to enhance shareholder value. Very laudable and at the end of the day what matters is what the substituted funds, or new funds, generate for the company. But the anxiety to generate earnings should not be so blinkered as to dismiss the very valid cash flow considerations.