Having the right capital structure in place is essential when it comes to supporting a company’s growth, achieving the flexibility needed to accommodate any unexpected bumps in the road, and harnessing opportunities for M&A when they arise. It also represents a significant consideration within a company’s overall approach to risk management.
For corporate treasurers, managing capital structure is an important area of responsibility, from striking the right balance between debt and equity, to making decisions about dividends and understanding the tax implications of different financing instruments. What’s more, given that the company’s capital structure can evolve over time, it’s important for treasurers to keep a close eye on market conditions and any developments that may necessitate a shift in approach.
With this in mind, what considerations should treasurers bear in mind when approaching the task of capital structure management?
Striking a balance
Capital structure is a term used to describe the particular mix of debt and equity that a company uses to fund itself. A company’s business operations, acquisitions and capital expenditures can be funded using a variety of sources, including equity (ie selling shares to raise capital) and debt (ie borrowing funds via debt instruments such as loans or bond issuance).
Different companies will approach this differently depending on factors such as the company’s size and industry, as well as the current macroeconomic environment. There are, of course, some important differences between the different sources of capital, such as:
Cost of funding. Broadly speaking, equity is a more expensive funding source than debt, as investors take on a higher risk than when lenders provide debt funding.
Leverage. Despite this, companies that take on high levels of debt experience a higher cost of debt due to the greater probability of default.
Accountability to shareholders. Shareholders own a portion of the company, meaning they will need to be consulted on certain decisions, whereas debt financing doesn’t give the lender control over the company.
Impact on cash flow. Regular debt repayments may adversely affect cash flow, whereas equity doesn’t include specific repayment obligations.
Tax deductibility. Interest paid on debt is usually tax deductible, unlike dividend payments on equity shares.
Risk in the event of liquidation. If a company goes into liquidation, a hierarchy is in place to determine which creditors are paid back first. Shareholders are at the bottom of the list and are therefore the last group to be paid.
When it comes to determining the optimal capital structure for a particular business, a number of factors will need to be taken into account. Venkat ES, head of Asia Treasury Products, Global Transaction Services at Bank of America (BofA) explains: “A company’s capital structure can be dynamic as it is dependent on shifts in its internal policies, local regulatory requirements (such as minimum or maximum shareholding), tax environment and liquidity situations (HQ and local), profitability, and commitment to local markets.”
In practice, many companies will opt for a capital structure that includes both debt and equity components. The relative proportions of debt and equity used by a company will determine its weighted average cost of capital (WACC), a calculation which states the weighted average of the company’s cost of equity and cost of debt. Traditionally the rule of thumb is that the best capital structure is the one which provides the lowest WACC. However, this is not set in stone, as David Blair, Managing Director, Acarate Consulting, explains in the box on below.
The treasurer’s role
Overseeing the company’s capital structure is an important element of the CFO’s responsibilities. PwC’s 2019 Global Treasury Benchmarking Survey, Digital Treasury – It takes two to tango, said that capital structure is a priority for 100% of CFOs – joint first with cash flow forecasting, and ahead of funding (98%) and currency risk (69%).
That said, corporate treasurers also have a key role to play in making sure the company’s capital structure is the best fit for its needs. PwC’s survey noted that an increasing push for internal sources of growth “creates an opportunity for treasurers to think more strategically about capital structure and the balance sheet.” Respondents to the survey identified capital structure as the fourth most important priority for treasurers, ahead of bank relationships, working capital, and technology and digital innovation.
“Capital structure management is a key pillar of a company’s risk management approach and an important area of responsibility for treasurers,” says Sonia Clifton-Bligh, Director – Regional Treasury Services Centre Asia Pacific at Johnson & Johnson. “It examines how we finance the overall operations and growth of the company by using different sources of funds, ie from its own balance sheet, capital raising or loans.”
For treasurers, the objectives of capital structure management may include maximising shareholder value, achieving the flexibility needed to realise opportunities for M&A, and reducing the cost of capital. In addition, a company’s capital structure will need to be sufficiently flexible to suit the organisation’s goals and requirements as economic conditions evolve. As such, achieving the right balance is something that will look different to different companies.
“Managing capital structure is a very important activity for a corporate treasurer, although the level of involvement may vary from company to company,” says BofA’s Venkat. He explains that capital structure has a direct impact on a company’s funding strategy, cash flow management, dividend repatriation, and debt management. “It also has an indirect impact on its FX/IR risk management and bank relations if local currency other than its HQ reporting currency is involved, where local bank support is needed especially in some restricted markets,” Venkat adds.