Thin capitalisation: practical guidance: measuring debt: how the nature of the commercial activity influences the level of debt
The arm’s length range of Debt:EBITDA or debt:equity ratio for a business depends on a number of factors that can be grouped into three broad categories:
- Commercial activity
- Business strategy
- Economic conditions
This page deals with commercial activity.
The arm’s length level of debt for financial businesses is usually measured by reference to a debt:equity ratio, though special considerations apply to deposit-taking banks and businesses that write insurance contracts.
These 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 are based on international requirements laid down by the Bank of International Settlements (known as the Basel ratios), but are negotiated with each bank by the FSA. In practice, UK banks will have more equity and often less long-term debt than the maximums permitted by the FSA, to leave headroom against any breach of regulations.
When considering whether a bank is thinly capitalised the correct approach is to determine how much more equity than 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 of foreign banks is dealt with. Concerns about the capitalisation of deposit-taking banks should be referred to specialists within HMRC’s banking sector.
These are also regulated by the FSA and are required to maintain sufficient equity and long-term debt capital to protect policy holders. The FSA have two requirements concerning capital: the minimum equity and subordinated debt capital requirements. These are calculated by reference to premiums and claims. If levels of equity and subordinated debt fall below the minimum, the FSA will suspend the insurer’s licence to write insurance business. The FSA requires all businesses writing insurance business to agree a level of capital capable of absorbing the losses from a one-in-200 year catastrophic event. This roughly translates to a BBB credit rating, and is called an Individual Capital Assessment (ICA). The amount of capital required to meet the ICA is always more than the minimum capital requirement, and in order to , have a buffer against breaching regulatory requirements, insurers will normally hold more equity and subordinated debt than required by the ICA. Guidance in the General Insurance Manual from GIM10221 makes some general comments on the attribution of profit to permanent establishments. Concerns about the capitalisation of insurers should be referred to specialists within the insurance sector.
Other financial entities
Most financial service providers will also be regulated by the FSA, but they will not be subject to the same capital requirements as deposit-taking banks. Where a financial service provider is not a regulated deposit taker but is functionally similar to one, its debt:equity ratio is likely to be similar, though lenders may view the regulated deposit taker a better risk and be more willing to tolerate greater leverage. The arm’s length level of borrowing will depend on the particular facts and circumstances, for example, finance leasing companies who are particularly exposed to the risk of losses on the residual value of leased assets will generally have a lower debt equity ratio than other financial businesses. There is further guidance on treasury and group finance companies at INTM503000, with material on conduit finance companies at INTM503050. These are intermediate lenders which take no little or no risk and may not be beneficial owners of the interest income.
Non financial businesses
An article on UK corporate capital gearing in the Bank of England Quarterly Bulletin of Autumn 2005 observed that, based on its analysis of company accounts data, capital-intensive businesses generally have higher gearing (p363(d) -article still available via the BoE website). This comment is, however, only 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. Land and buildings are likely to offer the greatest security, plant and machinery significantly less security, and intangible assets do not generally provide security for borrowing. More detailed guidance on asset-backed lending is given at INTM518000.
Land and buildings
The security provided by land and buildings allows businesses carrying significant real property on their balance sheets to be 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.
Plant and machinery
In general these assets provide less security for a lender, and will have little influence on the level of borrowing of a company. By the time a lender comes to seize and realise assets to recover funds, the assets will be those of a failed or failing business. Motor vehicles are an exception, so transport and vehicle distribution business can increase gearing by using their vehicles as security for lending.
The Bank of England Bulletin observes that businesses whose value is substantially composed of 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 Bank of England study 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 will be significantly lower than that of one which has not, so care must be taken to compare debt:equity on a consistent basis. Business strategy may also have an impact on the borrowing levels for businesses with intangible assets. Additionally, private equity owned businesses and acquisitive groups will have higher gearing immediately post-acquisition. Private equity is considered at INTM519000.