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Financial Management and Analysis of Projects : 4. Financial Management of Executing Agencies
4.4.7. Capital Structure Indicators4.4.7.1. Introduction4.4.7.1.1. Public sector and private enterprises need an appropriately balanced, adequate capital structure, even though for the former, the objective of return on capital may be tempered by socioeconomic policy considerations.4.4.7.1.2. It would be possible to provide all the capital of a public sector enterprise as equity and thus avoid all financial risks. This is undesirable since this would forego the benefits of the financial discipline associated with the obligation to service debt. Limits on the liability of public sector enterprises to contract additional debt also prevent the use of borrowings to postpone cost reductions (or increase of charges), to maintain earnings at an adequate level. 4.4.7.1.3. It is also an oversimplification to view the equity capital in a public sector enterprise as having no recognizable financial cost because the funds used have an opportunity cost regardless of where they are invested. Also the cost of capital is a legitimate cost that owners/consumers should pay, regardless of whether there is no debt in the structure of the enterprise. Moreover, in a public sector enterprise, earnings must be in excess of debt service obligations (and/or dividend payments on equity) to provide a safety margin, and to provide additional funds for investment. The previous paragraph is a typical commitment entered into by an enterprise to enable it to continue to incur debt, particularly to draw down the ADB's loan. 4.4.7.1.4. The enterprise can use these funds for its capital requirements or to pay dividends that the government can apply for other developmental or fiscal needs. Capital structure indicators serve to indicate an assurance (or otherwise) of the continued solvency and financial viability of revenue-earning enterprises by imposing prudent limits on their long-term borrowing. However, they are not designed as revenue-generating indicators and thus cannot be used as operating covenants. 4.4.7.2. Capital Structure as a Debt Limiter4.4.7.2.1. An EA that does not incur debt after agreeing to use a capital structure indicator, or refrains from further borrowing after a period of compliance, even though the agreed performance criteria subsequently may not be complied with, is not in breach until it again commences to incur debt.4.4.7.2.2. The limits of the indicator should be set to enable debt service obligations to be met under adverse as well as normal business conditions, taking into account business and financial risks. 4.4.7.3. Capital Structure and Risk Management4.4.7.3.1. Business risk refers to the inherent uncertainties, or variability of expected returns, related to the nature and type of business activity of a particular enterprise. The financial risk is the additional risk inherent in the obligations associated with borrowings (interest and debt repayment) which must be met irrespective of the results of operations.4.4.7.3.2. The foreign exchange risk is an extension of the financial risk when the obligations associated with borrowings (interest and debt repayment) that must be met irrespective of the results of operations are expressed in a currency other than the local currency. 4.4.7.3.3. The principal foreign exchange risk arises when the local currency declines in value against the foreign currencies in which the obligations must be paid, resulting in the cost (or value) of the obligation being increased by reason of the additional local currency required to purchase the requisite amount of foreign exchange to meet the obligation. 4.4.7.3.4. If the local currency increases in value against the foreign currency obligation, the borrower requires less local currency to purchase foreign exchange to meet the obligation (and therefore, in this case, there is no foreign exchange risk). 4.4.7.3.5. A well-managed entity with a low business risk will have a fairly dependable cash flow and can assume higher financial risks in the form of a large proportion of debt to equity in its capital structure. This would apply, for example, to a public utility with a relatively steady and increasing demand for its services, little competition from other sources of supply, and fairly dependable production facilities. On the other hand, an entity which may be subject to wide variations in demand and prices, such as a steel company or a coffee estate, is likely to have substantial swings in its cash flow from year to year. It should therefore have a relatively conservative financial structure with low fixed financial obligations. 4.4.7.4. Inflation and the Capital Structure4.4.7.4.1. The risk of inflation is another factor that affects the cost of capital and decisions on capital structure. Although inflation may lower the burden on servicing outstanding debt at fixed terms, it may increase the financial risk associated with loan capital, since the earnings of an enterprise may not keep pace with inflation.4.4.7.4.2. The interest payable on long-term loans at fixed terms may include a substantial inflation premium over the returns lenders would otherwise accept for the business and financial risks they are assuming. Alternatively, long-term loans may be available only if loan amounts and repayments are indexed for changes in the value of money, or if the interest rate varies with the current cost of borrowings. 4.4.7.4.3. The impact of inflation on financial risk is greatest when only short- or medium-term funds are available, and the enterprise is exposed to the risk of being unable to refinance at maturity or of having to pay higher interest rates for renewal. The risks associated with borrowings under inflationary conditions, therefore, must be carefully appraised in determining a prudent capital structure. Inflation also increases the working capital requirement of enterprises. 4.4.7.4.4. The negative effects of inflation often outweigh the positive effects of lower debt service, and after a few years, the impact may be of undercapitalization. 4.4.7.5. Equity versus Debt4.4.7.5.1. Equity investors, because they are subject to the prior claims of lenders and have no fixed promises of returns, will usually expect a higher return on their capital than lenders. Like lenders, equity investors will accept lower or higher returns when they judge the risks to be low or high. They will consider their risk to be lower when equity is high in relation to debt, and vice versa.4.4.7.5.2. Thus, when a private enterprise is being established, or is raising funds for expansion, the capital invested ideally should be structured so as to balance the lower financial costs of loan funds against the higher costs of equity capital and provide for long-term financial stability at minimum cost. 4.4.7.5.3. Differences in the capital structure of enterprises in the same industry or in industries with similar business risks may reflect varying management judgments on the trade-off between security and risk, or an unwillingness to adequately fund replacements or expansion, all subject to limitations imposed by protective covenants agreed with lenders. 4.4.7.6. Debt Service Coverage4.4.7.6.1. Section 3.6.3.3 discusses the application of this indicator in relation to investment projects. The debt service coverage ratio measures the extent of the coverage of an enterprise's debt service by its internal cash generation over a defined period.4.4.7.6.2. A performance of one means that there is precise coverage, while a performance in excess of one (e.g., 1.3) indicates a margin of safety in covering debt, plus yielding surplus funds for investment etc. This indicator recognizes that the terms of a debt are more significant that the amount in measuring borrowing capacity. Except for Financial Institution Indicators, the debt service coverage ratio is used for revenue-earning enterprises in all sectors, particularly for public utilities, transportation, and industry, including agro-industry. There are two versions of this indicator: (i) based on historical earnings, and (ii) based on estimated future earnings. 4.4.7.6.3. Version (i) is based on historical earnings. It can address either the latest completed fiscal year or a more recent 12-month period. It is more objective and certain than version (ii) which is based on estimates of future earnings. In calculating the internal cash generation, (i) permits an adjustment to be made for changes in sales prices introduced during the year as though they were in effect throughout the year. Nevertheless, this version (i) may be constraining because it gives no credit for the earning power of the investments to be financed by the proposed loan, or any other expected increases in earning power (ADB's loan agreement clause "Except as ADB shall otherwise agree" may be used to overcome this problem, where appropriate). 4.4.7.6.4. Conversely, an EA that fails to implement a project within the grace period of the related loan can be faced with debt servicing demands that cannot be met by the unfinished investment, which is not yielding revenues. 4.4.7.7. Debt-Equity Ratio4.4.7.7.1. Section 3.6.3.4 discusses the application of this indicator in relation to investment projects. The debt-equity ratio represents the relative proportions of these two sources of funds in the capital structure of an entity. This ratio is not appropriate for measuring FI performance.4.4.7.7.2. If a capitalization of $240 million is financed by long-term debt of $180 million and by equity of $60 million, the debt-equity ratio would be presented as 75:25. This conventional presentation is normally used for all sectors except FIs. 4.4.7.7.3. The debt-equity ratio indicator is normally used only for new enterprises, such as a "greenfield" industrial plant where, for lack of an earnings record, application of the debt service coverage covenant is not practicable. 4.4.7.7.4. Except for FIs, the debt-equity ratio helps to maintain a satisfactorily balanced financing plan in an enterprise's early years, but a debt service coverage covenant should be used also, because this is likely to become a more meaningful measure as output commences. It should then supercede the debt-equity ratio covenant after the first year or two of operations. 4.4.7.7.5. The considerations determining the magnitude of the debt-equity ratio are the same as those discussed for debt service coverage. It is generally inappropriate to have a debt-equity ratio higher than 60:40, but flexibility is permissible, depending on the sector or industry concerned, on the degree of capital intensity, and on the level of debt service commitments entered into. 4.4.7.7.6. Where the latter are not severe, a higher ratio may be admissible. For example, where the loan principal is repayable at the end of the term and inflationary conditions prevail; or the interest rate is fixed at a low level; or the prospects for continued intensive borrowing are negligible, giving prospects of declining debt- equity ratios. 4.4.7.7.7. Lower ratios than this are preferable for enterprises whose earnings are subject to wide fluctuations. Higher ratios, normally not greater that 70:30, may be acceptable for enterprises with very dependable earning power. However, there are a number of public sector enterprises, which are funded almost entirely by government debt, where the debt-equity ratio is 90:10 and sometimes 100:0. 4.4.7.7.8. In terms of sound commercial and financial management practice, such ratios are meaningless, but because the enterprises concerned are, in effect, government "departments", there may be no adverse performance effects, save that debt service could reach unmanageable proportions should the governments concerned ever seek to recover real interest rates. However, in many of these cases, the "debt" is often nonrepayable, and interest rates are usually kept low. The indicator in these circumstances has no credibility. 4.4.7.7.9. It should be noted, however, that one of ADB's long-term objectives for enterprises of this type is, as a minimum to achieve self-financing status, and as an optimum, to achieve privatization. For either option, an unbalanced debt-equity structure of 90:10 or higher will mean that the enterprise will be regarded in the capital markets as not creditworthy, and until it can adopt a structure around 60:40, is unlikely to attract institutional lenders. 4.4.7.7.10. However, an important side issue arises from the highly leveraged enterprises referred to above. While it may be reasonable to accept their status in terms of an abnormally high debt-equity ratio, the financial analyst must recognize that these enterprises are operating on free or very "cheap" capital. 4.4.7.7.11. ADB considers, generally speaking, that enterprises should pay for the use of capital, and that a reasonable interest rate should be levied. If this capital is not transferred in the form of loans and is injected instead as equity, this too has a price - probably a higher price than loan funds if it were sought in the money market. Therefore, the analyst should actively encourage the payment to government for this form of capital injection. 4.4.7.7.12. Any issues should be discussed at Project Preparation, and the RRP should contain a clear statement on the treatment proposed, and justification therefore, particularly if the market price of funds is not to be levied by government. 4.4.7.8. Debt Limitation4.4.7.8.1. Section 3.6.3.5 discusses the application of this indicator in relation to investment projects. The typical case when this restriction is sought through a loan agreement is when a public authority whose capital structure consists entirely or predominantly of debt, because of statutory requirements that all externally provided investment funds be advanced in the form of borrowing from government.4.4.7.8.2. It is used infrequently and only where debt service coverage or debt-equity covenants cannot be applied, primarily because the latter ratio is meaningless. For example, the equity may be zero, when all liabilities are in the form of government loans. 4.4.7.8.3. An absolute debt limitation covenant limits the amount of debt that may be incurred annually to an amount agreed between the borrower and ADB, and is either a specified amount expressed in absolute terms, or specified as a proportion of the total capitalization. The borrower would require ADB concurrence before exceeding this limit. 4.4.7.8.4. The limit for new debt is fixed at a relatively small amount, which, together with the internally generated funds that are forecast to be available, permits the borrower to carry out minor plant replacements or improvements without consulting ADB. Whenever the borrower plans a major expansion it must consult with ADB. This form of covenant has substantial disadvantages. It is related to a stated amount of debt without consideration of its terms and without taking into account changes in an enterprise's financial requirements or debt servicing capacity; and it severely restricts an enterprise's freedom of action. 4.4.7.8.5. A more constructive solution would be to agree with the borrower that a substantial part of any loan by the government to the public sector enterprise would be subordinated and treated as quasi-equity capital. This would permit the use of the debt service coverage or debt-equity ratio covenants. 4.4.7.9. Capital Adequacy Ratio4.4.7.9.1. Section 3.6.3.6 discusses the application of this indicator in relation to investment projects. The capital adequacy ratio indicator is used extensively in commercial banking, and is now being applied to most FIs. Section 6.4.3.1 describes the development, calculation, and application of this indicator in detail.
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