Treasury Practice

Managing capital structure

Published: Mar 2020

When it comes to optimising the company’s capital structure, it’s important to strike the right balance between debt and equity and ensure the company has the flexibility needed to harness growth opportunities. How can treasurers in Asia approach this important task, and what factors do they need to take into account?

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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.

Calculating leverage

David Blair, Managing Director, Acarate Consulting

How have companies traditionally calculated leverage?

Traditionally leverage was determined with reference to the capital asset pricing model (CAPM) and the WACC curve:

  • WACC combines the cost of debt and the cost of equity. Equity is generally more expensive than debt, especially after the tax shield on interest (interest on debt is tax deductible, whereas dividends on equity are not tax deductible). However, excessive leverage – ie too much debt – will drive up the cost of equity. This is because higher leverage increases risk, mainly due to the fact that higher interest payments may not be sustainable.
  • CAPM allows us to calculate the cost of equity with the (equity) market rate of return, plus the individual stock’s beta, which is the volatility of the individual stock compared to the market volatility.
  • WACC can be found online and on Reuters and Bloomberg. It’s still a fairly standard metric, though there is much academic debate about how exactly to calculate it. WACC is also used for things like corporate investment decisions, such as building factories, developing products and entering new markets.
  • Generally, companies with stable revenues can have higher leverage because they are very likely to be able to cover the interest payments. A typical example is power companies, as light and power are always needed.

What’s changed?

The current situation deviates from the traditional approach in a number of ways. For one thing, technology companies and other favourites ‘always’ run net cash balance sheets with no debt and tons of cash. Decades ago, this was because the technology sector was risky and needed a strong balance sheet to survive. Now, these are the biggest companies on the planet (and therefore hardly risky start-ups) and still have an abundance of cash. Academics cannot explain this (certainly not with formulae) and ascribe it to market sentiment and perception.

In addition, interest rates are at historic lows, and have been for a while. This makes it easier to cover interest payments so that companies can have much higher leverage than has been traditional. Creditors therefore have to look at interest cover in the P&L, rather than leverage (ie the debt to equity ratio) on the balance sheet. Of course, when (or if) interest rates revert to historic norms, then many companies will struggle to cover interest payments.

What does this mean for treasurers?

Treasurers can balance all this by managing the balance sheet towards a target rating, which effectively subsumes all the relevant metrics. Obviously, they also have to comply with any covenants on debt outstanding.

What to consider

Optimising the company’s capital structure is a task that includes a number of activities and considerations. “The types of activities that are likely to fall within the scope of capital structure management include defining appropriate borrowing levels to limit loan funding to that which the company can service without causing financial stress,” says Clifton-Bligh. “Additionally, decisions on dividend repatriation and capital injection also form part of the capital structure responsibilities of treasurers.”

In order to manage capital structure effectively, Clifton-Bligh says considerations include “the risk and cost of debt vs equity; matching cash flows to meet interest and capital repayment obligations, flexibility of those various instruments against the underlying need for financing, and the taxation implications of exceeding debt to equity ratios.”

Venkat, meanwhile, says that treasurers need to consider factors such as the following: the company’s internal liquidity situation; the level of commitment to local markets; debt and capital market conditions; whether the company is in an expansion or consolidation stage; the local legal/tax/currency control related regulatory requirements, including the ability to repatriate excess liquidity out of the country, tax treatments and key metrics including return on equity, debt-equity ratio, liquidity/current ratio, profitability, dividend paid rate.

Considerations in Asia

For treasurers in Asia, there are also some specific points that they will need to bear in mind. Clifton-Bligh points out that the maturity of the legal and financial environment, as well as the regulations in Asian countries, “may create challenges for treasurers as they conduct their capital structure activities.” She adds that examples of such challenges include “the availability of suitable debt products and tenure to match the company’s requirements, cost, taxation consequences of equity – some countries impose additional taxes on companies that meet a threshold of capital.”

BofA’s Venkat, likewise, says that treasurers may face challenges such as:

  • Legal requirements regarding the type of investments, percentage shareholding and local partner requirements.
  • Relevant tax regulations.
  • Currency control regulations.
  • Local management influence.
  • Capital support by local banks.

In addition, Venkat points out that capital structure is mainly driven by tax and is restricted by relevant local legal requirements. “Often, changes in market conditions can have considerable impact on the availability and accessibility to capital,” he says. “Corporate treasurers need to stay ahead by anticipating the changes and ensuring that the treasury can carry out critical functions such as liquidity positions, settlements and risk management.”

In conclusion, capital structure management is an important element of the treasurer’s responsibilities. While this is not something treasurers will determine in isolation, pinpointing the right balance between debt and equity – and managing this effectively over time – is key to ensuring a company has the agility needed to respond to evolving market conditions and harness opportunities. The coming months are likely to bring some significant challenges, particularly in Asia, so treasurers should continue to ensure the capital structure in place continues to be the best fit for the company’s needs.


Harsha Basnayake, Asia-Pacific Transaction Advisory Services Managing Partner, Ernst & Young

How significant an activity is managing capital structure in terms of the treasurer’s overall responsibilities?

We have always held a view that managing the capital agenda of the business is core to the survival of any management team because it underpins the longer-term success of the business. The capital agenda of any business represents a set of activities relating to: raising or accessing capital for growth or to fund day to day operations; investing or deploying capital to new investment opportunities that may be both organic and inorganic; optimising the use of capital in the business portfolio and preserving or managing the risk and adopting to changes in the business environment.

An efficient capital structure is the output of a well-managed capital agenda. While this should really be on the CEO’s and CFO’s agenda, the treasurer plays a very critical role in monitoring the broader macro-economic activities and balancing the short, medium and longer-term capital needs of the business. The treasurer is best placed to advise on what type of a structure permits the company to be agile, responding to diverse market conditions in managing its overall capital agenda.

To what extent can a company’s capital structure evolve over time?

A company’s capital structure has to evolve over time depending on the growth trajectory it is on. In a disrupted low growth environment, companies have to maintain a high degree of flexibility in their capital structure.

What factors do treasurers need to consider when managing the company’s capital structure?

This is a difficult question as these factors may vary depending on the circumstances confronting the business.

I would expect them to be guided primarily by the capital agenda activities undertaken by the company based on the growth trajectory that the business is on. Business success at the end is measured by the overall shareholder value creation as well as business resilience depending on the circumstances faced by the business – and treasurers present a barometer to guide where they should invest and how such activities should be funded.

For this to happen effectively, treasurers need to have sharp focus about the medium-term market volatility and be creative to map the funding mix for businesses.

How might market conditions affect how treasurers approach this topic in 2020?

We see a couple of challenges. We are experiencing a very volatile market – markets in our part of the world are experiencing low growth, are vulnerable to geopolitical tensions, and on top of that we are now faced with the coronavirus impact – which has really been a black swan event. Risk of recession in some of the markets is quite real. It is a time where treasurers have to be quick to act and have access to multiple capital sources so that there is flexibility to change course as needed.

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