INTM579100 - Thin capitalisation: debt: equity ratio

Example of a debt:equity ratio calculation

Consider the following extract from a company’s balance sheet, from the point of view of what might be included in a calculation of debt and what might be included in a calculation of equity.

The definition of debt for this purpose can be found in INTM579020, the definition of equity in INTM579030, and the definition of debt:equity ratio is:

Debt:equity ratio = The ratio of the total interest-bearing debt to the shareholders’ funds (equity)

Notes:

1. Interest-bearing overdraft granted by the bank to assist with cash flow management. Throughout the past four years the company has generally been overdrawn.
   
   
2. This £10m loan is made up of various interest-bearing loans from affiliates and a £1m interest-free loan from the parent company. The interest-bearing loans are, in fact, expected to continue into the following year, subject to negotiation.
   
   
3. None of the trade creditors is over 60 days old.
   
   
4. Fixed-interest bank loan made three years ago to assist with property purchase, due to be repaid in two years.
   
   
5. Floating rate loan from parent, made during the last accounting period.
   
   
6. Third party loan, repayable in ten years. Zero interest rate, but the loan was discounted at the beginning of the term so that when the repayment is made the effective interest rate over the ten years is 7.5% per year.
   
   
7. Revaluation of property is carried out by independent valuers every three years. The figure of £750k is made up of £500k by independent valuation two years ago and an estimate of the increase in the property value since then by the directors. Although the financial statements were audited, the auditors did not review specifically the revaluation reserve

It is possible that not all the information given in the notes above will be available at the time a debt:equity ratio calculation is being made, in which case several possible ratios may emerge, but based upon the information given the calculation might proceed as follows:

Debt:

• Bank overdraft £3.450m: there is indication that this is continuously being used as part of the capital structure of the company rather than as a cash flow support, so it ought to be included in the calculation of interest-bearing debt: include £3.450m.
• Loans from group members £10m: since the interest-bearing loans are expected to continue beyond the year, they should be included in the calculation of debt. The interest-free loan is due to be repaid soon, so it should not be included in either the debt or the equity calculations: include £9m. (The Inspector would undoubtedly query why interest-free debt was being repaid before interest-bearing debt.)
• Trade creditors £1.25m: trade creditors are not included unless they are outstanding long enough to be interest-bearing, which is unlikely in this case: nothing included. (Third-party trade creditors would not be included unless there was an extreme position of debt outstanding for a long period of time with interest being charged.)
• Other creditors £345k: there is no information about this item, but experience may suggest that they are not normally interest bearing, and in any case they are unlikely to make a material difference to the calculation: include nothing.
• Bank loan £4.5m: this is (presumably) arm’s length interest-bearing debt: include £4.5m.
• Loans from group members £75m: this is interest-bearing debt: include £75m.
• Debentures £10m: although ostensibly interest free, in fact interest is effectively accruing over the lifetime of the loan. A third-party lender would be unlikely to ignore such a commitment completely: include £10m.

Total debt: £101.95m

Equity:

• Called up share capital £2m: this is clearly normal equity: include £2m.
• Share premium account £0.5m: since this comprises funds paid for shares above the par value, it is part of the shareholders’ funds: include £0.5m.
• Capital redemption reserve £1.2m: This comprises profits set aside to redeem share capital, and is therefore part of the shareholders’ funds: include £1.2m
• Revaluation reserve £0.75m: only £0.5m of this reserve is independently verified. However, the financial statements have been audited, although the auditors did not consider this reserve. An initial position would be that the £0.25m included by the directors should be ignored, but detailed discussions will inform this decision: include £0.5m.
• Capital contribution £1m: if this is a genuine capital contribution (see INTM503050) it may be included in the calculation of equity: include 1m.
• Profit & loss account £21.25m: This is the normal accumulated profit transferred to reserves, making it part of the shareholders’ funds: include £21.25m

Total equity: £26.45m

Thus, the debt:equity ratio for 2002 works out at 101.95/26.45 = 3.85. Whilst not regarded as particularly high in some countries, in the absence of special circumstances it is high for the UK – see INTM579040 onwards and INTM581010.