How a business’ assets are financed determines its Capital Structure (also known as Financial Structure). There are generally two methods of financing available to a firm — equity, debt or a combination of both. The proportion of equity and debt, which a manager uses to finance his business, defines the Capital Structure for the firm. Theoretically speaking Capital Structure of a firm should not have an impact on its valuation – translation: value of a business should be independent of how it is financed. In reality, how a business is financed has a definite impact on its overall performance and the measurement and evaluation of that performance. The bottom line is financial structure of a firm has important ramifications for profitability, growth, returns and risks.
Capital structures vary from firm to firm and depend on both internal and external factors. For example, internal factors (say the size of operations, existing financial structure, access to capital, management’s historical performance, profitability & sustainability of profits) and external factors (like industry regulations, industry structure and layout, capital market conditions, economic environment, credit spreads) will have an impact on Capital Structure.
Firms employ external funds to finance various business operations. External funds differ by the required or expected return that investors need, when (or if) the funds need to be paid back and the order in which they are paid back.
Leverage is the amount of Debt, relative to Equity and /or Assets that a firm uses to finance its business. Leverage is the utilization of assets or funds, for which the firm has a to pay a fixed charge or fixed return.
To start a business venture, we need 1,000 dollars. We can borrow 500 dollars from our friends and invest 500 dollars from our own account. The friends 500 dollars need to be paid back in two years and we need to pay them 50 dollars a year for lending us the money.
When it comes to using the 1,000 dollars, we have two choices. We can go the local hardware store and buy a new laptop for our business for 800 dollars or we can lease it from the same store for 20 dollars a month. The second option is very attractive since it leaves the bulk of the 1,000 dollars with us for later use. The business still owes 800 dollars to the store, but that obligation can now be settled over a three-year period.
Using leverage, we did two things that would not be possible by using just my limited resources. We doubled the amount available for use by the business and then made the amount last longer.
Why is leverage important?
First, the level of debt determines the interest expense a business has to bear before it can pass on its earnings to shareholders. Interest expense is also a fixed cost and a business has to make interest payments irrespective of the level of production or profits.
Second, leverage increases the upside as well as the downside for a business. In profitable situations, leverage boosts the Return on Equity and in non-profitable situations, it decreases the Return on Equity. Higher leverage leads to higher risk as well as higher return in good times. However, in bad times, higher leverage leads to bigger dents in profitability and Return on Equity.
Ultimately, there is a tradeoff between the beneficial impact of leverage (the ability to earn more returns) and the risk enhancing effect of leverage (the impact on fixed costs due to interest payments). Businesses fail miserably when they misread this tradeoff.
When a firm takes on leverage, it takes on creditors. All existing creditors are interested in whether they will be paid back or not. Similarly, potential creditors are interested in whether the business has the ability to take on more debt or not. Therefore, the existing level of debt in a firm is a valuable indicator for existing and potential creditors. They can use this indicator, along with other financial indicators, to decide whether the firm is worth lending to.
Maturity or Tenor
Maturity is the duration after which an obligation, claim or loan has to be repaid to or by the firm. You may have heard the statement, “The loan matures in 60 days” or “The bond matures in three years”. This means that the loan needs to be repaid in 60 days and the bond will repay itself in three years. The term ‘Maturity’ is applicable to any kind of financial obligation that a business entity may have.
Counterparty A took a loan worth $80,000 from Nickel International Bank. The loan was taken for a period of 5 years with the agreement that the counterparty would pay 5% interest annually and repay the principal amount of $80,000 at the end of 5 years. Since the client was a new company in a very unstable environment, the agreement between the bank and the firm was quite extensive. Some of the terms were
- The borrower will maintain a 2:1 ratio between its current assets and current liabilities
- The borrower will not take on any additional debt without the consent of Nickel International Bank.
- The borrower will not sell of any assets without informing the Bank first
- The borrower will maintain its profitability level at a penny for every dollar of sales
- The borrower will not hire or fire any key management personnel without the approval of the bank.
- At any given year, Net Income earned by the borrower will be at least three times greater than the amount of the annual interest payment.
The six conditions above are called loan covenants and form part of the loan agreement. When the client violates any of the above six conditions, or fails to make interest payment in time, or fails to return the principal amount in time, it is in violation of the loan contract. Whenever the loan contract is violated, the firm is technically in default. A lender then has two choices. It can agree to work with the borrower and see what can be done to address the default – this is called the work out scenario. The idea here is to assess the situation and see what can be done to salvage it without taking extreme action. The other choice is to push and force the client to repay by using the legal system to attach the pledged collateral and collect by auctioning or selling the collateral.
A third choice comes into play when borrowers are aware of their inability to pay and file for bankruptcy as a preventive measure to ensure that the assets they need to carry on and continue operating the business are not taken away by lenders. In the US, some bankruptcy statutes lead to a reorganization (Chapter 11) where a borrower emerges from the protection in better shape and with reworked and renegotiated credit agreements that improve the chances of the loan being repaid. Other bankruptcy statues lead to liquidation (Chapter 7) . Bankruptcy is a legal status where a lender declares that the assets on his books are not enough to pay off creditors and seeks legal protection. Within the US Bankruptcy code, Chapter 12 and Chapter 13 are variations on the Chapter 11 filing.
Interest rate or profit rate
Interest is the charge or fees that a company pays when it takes on a loan. The lending institution decides the rate of interest and terms of payment at the time the loan is approved. The interest rate (the amount of interest) that a borrower pays depends on factors such as the:
- Amount of the loan
- Term or Maturity of the loan
- Creditworthiness of the borrower
- Economic and market conditions
- If the loan is backed or secured by assets that the lender can claim in event of default (secured versus clean or unsecured lending)
Interest rates can be fixed or floating. Fixed interest rates are those that remain constant over the entire life of the loan, whereas, floating rates are revised by the lending institution after every few months or weeks.
Some credit facilities require payment of fees to the bank by the borrower on the amount of the loan that has not been utilized. These are ‘Commitment Fees’ and are expressed as a percentage of the unused (i.e. available) portion of the commitment. For example, a company may have a $200 million revolver with a commitment fee of 30 basis points (bps) or 0.3%. If it borrows 50 million out of the $200 million and does not borrow the remaining $150 million before year-end, it will pay a $450,000 annual commitment fee (i.e. $150 million x 0.30%).
Commitment fees are charged by the bank since funds allocated to a particular customer are not being utilized by the customer. The same funds could have been lent to another borrower and earned interest income. Hence, commitment fees compensate the bank for income that could have been earned if the money, currently lying idle, would have been put to use elsewhere.
Commitment fees charged depend on a number of factors:
- The credit rating of the borrower is an important consideration. A company rated AAA by Standard & Poor may pay .05% (5bp) commitment fee, while a BBB rated company may pay 0.25% (25bp)
- Length of the commitment
- Lending institutions also look at the percentage of Assets that are financed through Equity. Fees decline in amount with an increase in this percentage (higher the equity investment, lower the commitment fees)
The credit culture of a lending institution is the unique approach it takes towards putting capital at risk. This includes approval and managing loans and their associated risk (read: credit risk). Several variables have an impact on the credit culture of a lending institution, for instance the role of an independent credit committee, a focus on a specific sector, segment or community, lending policies & procedures, aggressive or conservative marketing strategy, and the processes used for screening a credit application.
When a lender extends a loan, he bears the risk that the borrower will default (will not pay interest and/or the principal amount or violate loan covenants). This uncertainty is called credit risk. The amount at risk is called the credit exposure.
In the event of default, the bank can claim asset/s that the business has pledged as collateral. The lender has a right to sell or liquidate the pledged assets if the borrower is unable to pay back the loan. However, liquidation costs can further reduce the value of the collateral. These may include legal services for transfer of ownership or possession as well as the transaction costs of selling assets under adverse market conditions.
A lender has to assess the intent (willingness and ability) of a business to pay off its obligations when due. A creditworthy customer is expected to generate enough cash flows to cover operating expenses, interest and principal payments on existing liabilities, taxes and still make a decent profit. Beyond intent, other criteria include existing debt and its load on operating income, historical performance (track record) of the business, collateral, management’s competence (capability), profitability, industry trends & market conditions.
Work-out and Charge off
What happens when a lender is informed that a customer is going to default on a loan?
Before a loan is written off or assigned to the non-performing (troubled) portfolio, a work out team will try to assess the situation and see if the loan is still salvageable. Is the default due to temporary market conditions and will the situation improve with an improvement in environmental factors? What is the loan to value ratio for the collateral? If the bank works with the customer, will the probability of repayment improve or worsen? Is the default due to covenant violations and are the violations minor or serious? Most lenders have a cutoff point for trouble. If the situation is too far gone, they will cut their losses, take a charge (balance sheet and income statement hit), assign the loan to the non-performing team and move on. The non-performing team will generally sell the loan to specialists who specialize in working with non-performing customers and troubled loans. However, this will not be true for all banks.
When a lender decides to restructure the loan, or renegotiate the terms and conditions, in an attempt to receive maximum possible payment, the process is called work-out. When a lender is sure that he will not be able to receive any payment or a partial payment at best, he writes off or charges off the loan. Loan assets on the balance sheet are adjusted and the charge for the reduction is passed through the income statement.