Thin capitalisation: practical guidance: measuring debt: debt-based ratios (gearing or leverage)
Debt ratios are part of the set of tools by which a borrower’s ability to borrow and to maintain a particular level of debt are measured and monitored. See INTM515010 on covenants for agreements.
A debt ratio in a loan agreement or thin cap agreement is there to monitor a borrower’s ability to carry the debt and undertake the longer-term task of discharging it. Levels of interest-bearing debt are measured at agreed intervals and set against the level of equity or earnings. Ratios which track the relationship between earnings and interest are discussed from INTM516000 onwards, with Earnings Before Interest, Tax, Depreciation and Amortisation (“EBITDA”) explained at INTM516060.
The duration of intra-group debt may be unclear. Being intra-group, terms may not be set out formally, may be sketchy or in practice may not conform to what has been agreed on paper. For example, much intra-group debt is repayable at thirty days’ notice, but that condition is routinely ignored. Information on the purpose of the lending, the parties’ intentions, and the practical prospects for repayment may help to shed light on the precise nature of the facility.
It may be unrealistic to assume that debt taken on to fund a specific acquisition will in reality be paid off. High levels of debt may be accepted by HMRC for a period following a major acquisition, with the expectation of a return to “steady state” levels, but money is fungible, particularly in intra-group money, and a certain amount of acquisition debt may eventually merge into the “pot” of money which supplies working capital.
The Debt:EBITDA ratio
The Debt:EBITDA ratio measures the relationship between debt and profitability. It is common in third-party lending agreements for the general run of trading companies. EBITDA stands as an approximation of cash flow, as explained at INTM515030. In practice, EBITDA may be subject to fine-tuning, for example, to take account of non-cash accounting entries in the profit and loss account or actual capital expenditure.
For thin cap purposes this is the ratio of total interest-bearing debt to shareholders’ funds.
The components of both sides of this ratio may be subject to discussion and adjustment to reflect particular circumstances.
Debt:equity ratios feature most commonly in loan agreements for financial businesses such as motor finance or leasing companies, where money is almost the trading stock of the company. HMRC sector and transfer pricing specialists may be able to help identify appropriate ratios for these types of businesses. The ratio of debt to equity is also a vital component of the regulation of businesses such as banks and insurance companies.
A company which is highly leveraged will have a high proportion of debt compared to its equity. Leveraging or “gearing up” is the process of increasing that proportion. Private equity deals, by which companies are acquired using high levels of debt are known as “leveraged buy-outs”. See the chapter on Private Equity starting at INTM519000.
Even if the debt:equity ratio is not featured as a covenant in an agreement (see INTM515010), the relationship between debt and equity remains an important indicator of the strength of a company’s financial position. Equity forms the backbone of a company, and the relationship between what a company owns and what it owes. It would certainly influence the lending decision.
Definitions of debt are considered at INTM517020, and equity or shareholders’ funds at INTM517030.
Highly leveraged businesses
If a company has a high debt:equity ratio compared with the typical profile for companies in the same business sector, this may indicate it has been aggressively financing growth of the business with debt, which may explain a level of debt not present in its peers. However, the reason for being highly leveraged may be wholly or partly a transfer pricing one, namely, that the company is carrying more debt than it could or would at arm’s length.
As a consequence of high interest costs, aggressive leveraging can result in volatile earnings and a greater risk of business failure. Generally, businesses attract external comment and concern when the leverage ratio reaches 100% (a debt:equity ratio of 1:1), and the gearing of major plc’s is well below this figure. Plc ratios - a whole range of them - are available via numerous sites, including the finance sections of online daily newspapers.
Private equity presents a different business model and should be considered in its own light rather than by comparison with “traditional” business investment. See INTM519000.