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 INTM578110 - Thin capitalisation: debt ratios - debt repayment: Example: the components of a debt:equity ratio calculation

This exercise was devised when debt:equity ratios were more commonly employed as the basis for thin cap covenants, and although these are seen less often, the exercise it still useful in demonstrating what might be included in a calculation to allow consideration of the relative proportions of debt and equity in a company, still an important consideration.

The definition of debt for this purpose can be found in INTM578020, the definition of equity in INTM578030, and the definition of debt:equity ratio is:

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


 

Note

2008

 

 

£’000

Creditors due within one year

 

 

Bank loans and overdrafts

1

3,450

Loans from group members

2

10,000

Trade creditors

3

1,250

Other creditors

 

345

 

 

 

Creditors due in more than one year

 

 

Bank loans and overdrafts

4

4,500

Loans from group members

5

75,000

Debentures

6

10,000

 

 

 

Share capital and reserves

 

 

Called up share capital

 

2,000

Share premium account

 

500

Capital redemption reserve

 

1,200

Revaluation reserve

7

750

Capital contribution

 

1,000

Profit & Loss Account

 

21,250


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 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 £750,000 consists of £500,000 representing the conclusion of an independent valuation conducted two years ago, and an estimate of the increase in the property value since then, made by the directors. Although the financial statements were audited, the auditors did not specifically review 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 on the information given the calculation might proceed as follows:

Debt:

  • Bank overdraft £3.450m: there is indication that this is in continuous use 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 £1m 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. (HM Revenue & Customs should query why interest-free debt was being repaid before interest-bearing debt. Interest-free debt is akin to equity, and debt is repaid before equity)
  • Trade creditors £1.25m: trade creditors are not included unless they are outstanding long enough to become 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 at 7.5% 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, and although the financial statements have been audited, 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. Uncertainty can be satisfied by an assurance in the agreement that the capital contribution will remain in place for the duration of the agreement.
  • 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 2008 works out at 101.95/26.45 = 3.85. This would be very high for most businesses, and in the absence of special circumstances it would be treated as excessive - see INTM578040 onwards and INTM581010.