INTM578060 - Thin capitalisation: debt ratios - debt repayment: How the nature of the commercial activity influences the amount of debt

The arm’s length range of Debt:EBITDA or debt:equity ratios for a business is dependent on a number of factors that can be grouped into three broad categories:

1. Commercial activity
2. Business strategy
3. Economic conditions (The arm’s length level of debt can be affected by macro economic conditions)

This page deals with commercial activity.

There are a number of academic studies of trends in corporate gearing. One publicly available study is contained in the Bank of England’s Quarterly Bulletin of Autumn 2005 (available online at: http://www.bankofengland.co.uk/publications/quarterlybulletin/qb050303.pdf). The observations in this paragraph come from both practical case work experience and the conclusions from the Bank of England (BoE) study. The academic studies are high level analyses of large populations and therefore the conclusions reached are based on averages and should be treated a general guide to what may be expected given a certain set of circumstances rather than rules set in stone. The degree to which a borrower would be expected to behave according to the average trends will depend upon its individual facts and circumstances.

Financial businesses

• The arm’s length level of debt for financial business is usually measured according to a balance sheet ratio. There are special considerations for deposit-taking banks and businesses that write insurance contracts, otherwise debt:equity is normally the appropriate measure. Goodwill does not provide security against borrowing so it is important to look at equity adjusted the adjusted to exclude goodwill in financial cases.
• Banks are regulated by the Financial Services Authority (FSA), which requires certain levels of equity and long-term subordinated debt capital to protect depositors. The levels of capital, though based on international requirements laid down by the Bank of International Settlements (referred to as Basel ratios), are negotiated with each bank by the FSA. In practice UK banks will have more equity and often less long-term debt than is required by the FSA. When considering whether a bank is thinly capitalised the correct approach is to determine how much equity in excess of the minimum regulatory requirement a bank would carry at arm’s length. The principles for calculating bank capital are set out starting at INTM267750 where the attribution of capital to permanent establishments is dealt with.
• Insurance companies are also regulated by the FSA and are required to maintain sufficient equity and long-term debt capital to protect policy holders. The equity and subordinated debt capital requirements are calculated by reference to premiums and claims. The FSA require all businesses writing insurance business to submit a calculation of their solvency as part of their regulatory return. The principles for calculating insurance capital are complex, and reinsurance and securitisation arrangements have a significant impact on insurance company capitalisation. Guidance in the General Insurance Manual from GIM10221 makes some general comments on the attribution of profit to permanent establishments. In general the large UK insurance groups carry very little debt that does not qualify as subordinated debt capital and like banks they generally have more equity and less subordinated debt than the minimum required to meet FSA solvency standards. As the FSA calculation of solvency for insurers is based on premiums written and claims made, debt:equity will only be a proxy measure for solvency. The debt:equity ratio for pure general insurers is usually significantly below 1:1. The debt:equity ratio of insurers that underwrite a significant amount of Life business can be higher and this reflects the fact that the FSA allows Life insurers to recognise certain assets that are not recognised in the insurer’s balance sheet.
• Thin capitalisation is unlikely to be a risk where the borrower is a bank or insurer which is subject to the capital or solvency requirements of the FSA and which carries a surplus of equity above the regulatory minimum. However the current regulatory regimes look at the capitalisation and solvency of individual entities. Where the UK group contains a mixture of regulated and unregulated entities, the UK group can be thinly capitalised if excessive debt is held in the unregulated entities.
• Other financial entities. Most financial service providers will be regulated by the FSA in order to provide protection for their customers, but they will not be subject to the capital requirements as deposit-taking banks. Where a financial service provider that is not a regulated deposit taker is functionally similar to a regulated deposit taker, its debt:equity ratio is likely to be similar. Lenders may view the regulated deposit taker a better risk and be more willing to lend. The arm’s length level of borrowing will depend on the particular facts and circumstances; for example, finance leasing companies where there is exposure to the risk of losses on the residual value of the assets leased the business will generally have a lower debt equity ratio than other financial businesses. There is further guidance at INTM507000 for treasury companies and INTM567000 for conduit companies.

Non financial businesses

• The BoE Quarterly Bulletin observes that, based on its analysis of company accounts data, capital-intensive businesses generally have higher gearing (p363, d). It is important to acknowledge that this is a general observation and there may be other factors that influence more strongly the level of borrowing taken on by a business. The underlying reason for the relationship between assets and gearing is that assets can be used as security for borrowing. Different types of assets offer different levels of security, broadly land and buildings offer the greatest security, plant and machinery significantly less, and intangible assets do not generally provide security for borrowing. More detailed guidance on Lending Against Assets is given at INTM579000.
• The security provided by land and buildings allows businesses that carry significant real property on their balance sheets to be more highly geared. Lending against the value of the property portfolio is common in a number of business sectors, including construction, property letting, utilities, residential and care homes, hotels, restaurants and pub groups. In recent years UK retailers have borrowed against their property portfolio. Not all property provides the same level of security so the level of borrowing will be sensitive to the type and quality of the property. Private Finance Initiative businesses are a special case and further guidance can be found in INTM568000.
• In general plant and machinery provides little security for a lender and will have little influence on the level of borrowing of a company. Motor vehicles are an exception so transport and vehicle distribution business can increase gearing by using their vehicles as security for lending.
• The BoE Quarterly Bulletin observes that businesses whose value is substantially composed of the value of their intangibles are likely to be less highly geared than capital-intensive businesses. The bulletin identifies media, pharmaceutical and information technology/high tech as businesses with low gearing. Professional and consultancy services also come within this category. The study by the BoE measured gearing relative to the value of the company; this is the same as recognising the intangibles in the company balance sheet which results in a corresponding increase in the value of equity. The apparent debt:equity ratio of a business that has recognised intangibles on its balance sheet and one that has not will be significantly lower, it is therefore important to compare debt:equity on a consistent basis. It is also important to recognise that business strategy can have an impact on the borrowing levels for these sorts of businesses and higher gearing for private equity owned businesses and acquisitive groups is to be expected. Private equity is discussed in more detail from INTM580000.

In examining financial businesses in the banking and insurance sectors, it is advisable to consult International Issues Managers (IIMs) and transfer pricing specialists working in the financial sector early on in the risk assessment process. There are also a great many “financial businesses” which are not regulated in the direct way that the FSA impacts on, for example, banks’ levels of capital; most of these provide services though often they are associated with regulated businesses. The IIM or transfer pricing specialist will be able to advise whether a knowledge of the banking and insurance sectors is needed to understand the workings of these often consumer-facing businesses.