OT22060 - Interest and Financing

Lending Practice: Introduction

In order to form a view on whether or not borrowing is in existence or is proposed at a level higher than would be possible in the absence of the special relationship it is necessary to understand something of the process that a bank or other lending institution would go through in lending to a company. One has to consider whether a bank etc, would accept the company’s proposal and would lend at the level which the company is proposing to borrow. This understanding must start with an appreciation of the different role played by debt and equity from the point of view of the provider of the funds. Borrowers may have a variety of reasons why they want to raise capital by way of either debt or equity but the source of the capital will almost always be interested in the level of risk and reward.

Loans will usually carry only a fixed rate of return. It would be unusual for them to be in the form of a fixed rate of interest but more typically a fixed margin will be taken above a moving interest rate used as a reference point. Thus a bank may lend at LIBOR plus ½% in the expectation that it can raise funds at an overall cost of LIBOR minus ¼%. (The LIBOR rate will depend on the length of borrowing. It is usual for the six month LIBOR rate to be used.) Although the actual rate charged will fluctuate, the margin made by the bank, ¾% in this example, is fixed. It is also relatively small, in particular it is small in relation to the capital at risk and so the bank will only lend on such terms if its risk is perceived to be small.

In the simplest terms, if the bank has a large portfolio of loans amounting to some billions of pounds then if the expected profit margin on these is of the order of 1% per annum it must have confidence that on average the chance of a customer failing to repay a loan of x years duration is lower than 100 to x. Otherwise it will expect to lose by way of bad debts more than it recovers by way of interest. This is more by way of a theoretical example than an expression of real experience. In practice the bad debt experience may turn out to be much worse than anticipated.

To some degree bankers will lend on higher risk projects in exchange for a higher interest rate margin. Thus a small company with a less well established history will pay a bigger margin over LIBOR than a larger company. Similarly if a bank’s proportion of the overall borrowing is relatively small it may accept a smaller margin than if it is bearing a very high proportion. Indeed the strongest oil companies will be seen as a better risk than some banks and may be able to borrow in the Eurodollar markets at better rates than many banks. This borrowing would be on the strength of its world-wide assets in general without recourse to any specific project. There is however a strict limit to the extent to which a bank will lend more in exchange merely for a higher interest rate. There is also the question of whether the borrower would be prepared to borrow so much from an unconnected bank. If a project is inherently uneconomic it will not be improved by increasing the interest charge it has to service. Therefore OTO does not accept that a higher rate of interest ought to be charged because a company is thinly capitalised.

It is equity that is needed to finance high risk projects. Equity implies a high risk but a higher potential rate of return. It is not usual for banks to take equity in oil companies (or other companies) though there is some cultural variation from country to country. In Japan for example it seems to be the practice for companies to borrow to a greater extent than in the UK or the US; and in Germany bankers may be more likely to take a true equity stake in a company to which they also lend money. This may reflect the low interest rates (by British standards) associated with hard currency. OTO would not accept a higher than normal level of borrowing in a Japanese company in the UK, that was sterling based, just because it was Japanese.

All companies will, in the absence of a special relationship with the lender, have a mixture of debt and equity which will reflect the nature of the company’s activities, its strength and history as well as the business it is in. An arm's length lender will certainly wish to be clear as to a customer's history and the composition of the business portfolio as part of the general background in considering a particular set of proposals.

A lending institution may therefore agree to lend on the basis of a particular debt: equity ratio and the presence of a degree of cover of income over interest. There is a wide disparity between consumer debt: equity ratios and commercial practice. This written, the simplest and most familiar example of this is a Building Society or Bank mortgage for house purchase. If it offers to lend 90% of the cost of a house with the debt being three times the income of the borrower with a 10% interest rate then the debt: equity ratio is 9:1 and the income covers the interest charge 3.3 times. In this example the debt: equity ratio is high as the risk is perceived as being low. But there is a world of difference between a personal customer seeking finance for house purchase and a large corporation borrowing and/or arranging financial facilities.

It is accepted there are wide differences between companies and in any detailed discussions everything will turn on the actual and particular circumstances. It is therefore necessary to caution against heavy reliance on generalities. But, this written, in the broad generality of cases it is often accepted by a third party lender that a debt to equity ratio of 1:1 or less combined with income cover over the interest charge of three times or more would give sufficient comfort.

However it cannot be emphasised too strongly that there can be and are no hard and fast rules; application of the arm’s length principle means that each case has to be considered on its own facts and circumstances.