Thin capitalisation: practical guidance: measuring debt: example: the components of a debt: equity ratio calculation
Whether or not a debt:equity ratio is intended to form part of the thin cap agreement, the relative proportions of debt and equity must, nevertheless, be considered.
The ratio of the total interest-bearing debt to the shareholders’ funds (equity)
|Creditors due within one year|
|Loans from group undertakings||2||10.0|
|Creditors due after more than one year|
|Loans from group undertakings||5||75.0|
|Share capital and reserves|
|Called up share capital||2.0|
|Share premium account||0.5|
|Capital redemption reserve||1.2|
|Profit and loss account||21.3|
- The bank overdraft was granted to assist cash flow. The company has had a significant overdraft for each of the past four years.
- The loans from group undertakings are interest-bearing except for a £1m interest free loan from the parent company. The interest-bearing loans from group undertakings that are falling due within one year of £10m are repayable on demand, though relevant entities have confirmed no repayment will be demanded for at least one year.
- No trade creditor is over 60 days.
- The bank loan has a fixed rate of interest and was made three years ago to assist with a property purchase. It is repayable in full at the end of 20X3.
- Floating rate loan from parent, made during the last accounting period.
- The debenture loan is repayable at the end of ten years. The loan was issued at a discount so when the repayment is made the effective interest rate over the ten years is 5% per year.
- Company property is revalued every three years by independent valuers. Between these dates, company property is revalued by the directors. The revaluation of reserve of £0.8m consists of a revaluation of £0.5m following the conclusion of an independent valuation conducted two years ago, and a directors’ estimate of £0.3m.
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:
- Bank overdraft of £3.5m: the information provided indicates this is a component of the capital structure of the company rather than a short term facility, so it ought to be included in the calculation of interest-bearing debt: include £3.5m.
- Loans from group undertakings of £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. (HMRC 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 of £1.3m: trade creditors are excluded because they have not been outstanding long enough to become interest-bearing.
- Other creditors of £0.4m: there is no information about this item, but it is unlikely this creditor is interest-bearing, and in any case, this balance is unlikely to have a material impact on the calculation: include £nil.
- Bank loans of £4.5m: this is (presumably) arm’s length interest-bearing debt: include £4.5m.
- Loans from group undertakings of £75m: this is interest-bearing debt: include £75m.
- Debentures loans of £10m: this was issued at a discount though interest is effectively accruing at 5% per annum over the term of the loan. This would not be ignored by a third party lender: include £10m.
Total debt: £102m (£3.5m+£9m+£4.5m+£75m+£10m)
- Called up share capital of £2m: this is clearly equity: include £2m.
- Share premium account of £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 of £1.2m: This comprises profits set aside to redeem share capital, and is therefore part of shareholders’ funds: include £1.2m
- Revaluation reserve £0.8m: only £0.5m of this reserve is independently verified. The £0.3m revaluation adjustment made by the directors should initially be ignored, though this point should be reconsidered if evidence is provided that this further valuation adjustment is appropriate: include £0.5m.
- Capital contribution of £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 a condition in the agreement that the capital contribution will remain in place for the duration of the agreement.
- Profit and loss account of £21.3m: This is the normal accumulated profit transferred to reserves, making it part of the shareholders’ funds: include £21.25m
Total equity: £26.8m (£2m+£0.5m+£1.2m+£0.8m+£1m+£21.3m)
Thus, the debt:equity ratio for 20X0 works out at £102.0m/£26.8m = 3.8. This is very high, and in the absence of special circumstances it would be treated as excessive.