INTM578010 - Thin capitalisation: debt ratios - debt repayment: Debt-based ratios (gearing or leverage)
Debt-based ratios often regarded as reflecting a borrower’s ability to carry the debt and undertake the longer-term task of discharging it. Ratios for the relationship between earnings and interest are discussed from INTM577000 onwards, with Earnings Before Interest, Tax, Depreciation and Amortisation (“EBITDA”) explained at INTM577060.
The debt which will be of most interest is long-term debt, by definition the debt which it is expected will take some time to pay off. It may not be apparent in intra-group debt whether debt is long-term or short-term, but some enquiry as to where the money is tied up and what scope the borrower has for paying down the debt should help resolve that issue.
It can be misleading to assume that debt taken on to fund a specific acquisition will be paid off down to the last penny. Higher levels of debt may be accepted by HM Revenue & Customs for a period following a major acquisition though not indefinitely, but money is fungible, and a certain amount of acquisition debt may eventually merge into the “pot” of money which supplies working capital and further acquisitions.
The ratio of Debt to Earnings Before Interest Tax Depreciation & Amortisation (Debt:EBITDA)
The Debt:EBITDA ratio gives some indication of a company’s ability to meet its financial obligations. It is more commonly used in third-party lending agreements than a debt:equity ratio, certainly for conventional trading companies not involved in “financial businesses” such as leasing. Measuring debt against an approximation of cashflow provides an idea of how long, hypothetically, it would take the borrower to repay debt. This measure as it stands appears to make the somewhat unrealistic assumption that the business has stopped paying interest and tax, that working capital is static, and that there is no investment in new capital items, but it is a popular measure in agreements, certainly for non-financial businesses, and therefore acceptable to HMRC, though debt:EBITDA is usually further adjusted to take account of other obligations, such as future capital expenditure.
Debt:Equity Ratio
The simplest definition used for debt:equity ratio is the ratio of total debt to shareholders’ equity, though that is in practice subject to a number of adjustments in practice, such as the exclusion of short-term debt or non-interest-bearing debt. For the purposes of the discussion of debt:equity ratio in this module this definition will be used:
Debt:equity ratio = the ratio of the total interest-bearing debt to shareholders’ funds (equity)
Debt:Equity measures the gearing or leverage of a business. These synonymous terms describe the relationship between a company’s debt and its capital. A company which is highly leveraged will have a high proportion of debt as compared to its equity. Leveraging is the process of increasing that proportion. Private equity deals, by which companies are acquired using high levels of debt are known as “leveraged buy-outs”. See the chapter on Private Equity starting at INTM580000.
Even though the debt:equity ratio is a much less common feature of agreements with HMRC than was the case a few years ago, the relationship between the two can be an important indicator of the strength of a company’s financing, even if other ratios are to be used in any agreement. It would certainly be a ratio which any prospective lender would be very much aware of and would be expected to take account of in the lending decision.
Definitions of debt are considered at INTM578020, and equity or shareholders’ funds at INTM578030.
A high debt:equity ratio in relation to the typical profile for companies in the same business sector is usually regarded as an indication that a company has been aggressive in financing its growth with debt. The result can be volatility of earnings from the effect of the additional interest expense. Generally, businesses attract external comment and concern when the leverage ratio reaches 100% (a ratio of 1:1) and the gearing of major plc’s is well below such a figure. Plc ratios - a whole range of them - are available via numerous sites, including the finance sections of online daily newspapers.
Debt:equity is generally favoured as a measure by financial businesses such as car finance companies or leasing companies, where money is almost the trading stock of the company. Sector and transfer pricing specialists within HMRC will be able to help identify appropriate ratios for these types of businesses.
