Capital Structure : CRISIL’s Perspective

Rating of a instrument is a fairly detailed process, which comprises of evaluation of the business as well as the financial strength of the issuing company. The analysis of the financial risk profile includes evaluation of both the past , the present as well as the expected future performance of the company. Some of the areas looked at while evaluating the financial position of the company include size of the company, profitability, extent of gearing, flow patterns, etc. One of the important factors considered while analysing the financial risk of a company is its capital structure. This article discusses CRISIL’s treatment and analysis of a company’s capital structure as well as its impact on the overall rating.

Gearing

Gearing is an indicator of the capital structure of a company reflecting the extent of borrowed funds in its funding mix. Some of the ratios used in the computation of gearing are :

· Total Debt / Tangible Networth · Total Debt / Adjusted Networth · Total Debt + off funding liabilities / Tangible Networth · Total Debt + off balance sheet funding liabilities / adjusted Networth

Given below is an explanation for the various constituents of gearing. It should be noted that for the purpose of computing gearing, the classifictaion of funding sources into one of debt or is not always obvious and is based on their features.

Debt

Any instrument, which carries a fixed liability, is treated as debt. This includes all kinds of long term as well as short term debt.

Long Term Debt Debt instruments having a tenor of more than one year are considered as long term debt and include debentures, bonds, deferred payment credit, term (rupee as well as foreign currency) etc.

CRISIL also considers certain instruments such as preference share capital, interest free sales tax (IFSTL), optionally convertible debentures, etc as long term debt. The rationale behind this is outlined below :

· Preference shares have fixed yearly dividend obligation and usually have to be redeemed on maturity. This is unlike in the case of normal equity stock where the company does not have the obligation of dividend payment on a periodic basis and the shares are not usually required to be redeemed unless the company decides on a buyback of its shares.

· IFSTL is given to a company by the Government as an incentive to attract investments in particular geographical areas. The usual scheme is to pay the sales tax collected on the sales of a year after a period of 9-15 years without any interest. Since the amount is a liability on the company it is treated as a part of debt.

· Optionally convertible debentures are debt instruments which can be converted to equity at a specified date and the choice of conversion into equity is at the hands of the investors. Typically, a conversion is opted for in case the market price of the stock is higher than the conversion price. Since this implies that there is a possibility of the issue remaining as debt in the company’s books, CRISIL treats such instruments as debt till the time of conversion into equity.

Short Term Debt Traditional measures of focusing on long term debt have lost much of their significance, since companies rely increasingly on short term borrowings. It is now commonplace to find permanent layers of short term debt, which finance not only working capital but also an ongoing portion of the base. The short term debt includes borrowings in the form of bank borrowings, commercial paper, inter corporate deposits, fixed deposits and any other short term debt having a tenor of less than one year. This could also include short term financing from subsidiary companies, promoters and other entities.

Companies normally show borrowings taken by way of bill discounted with banks and other lending institutions as a part of contingent liabilities in their books. However, since this is a funding source for the company, CRISIL treats bill discounting as debt and factors the amount in the total debt calculation.

Off balance sheet funding According to Indian practices, certain kinds of financing are not required to be treated as debt in the books of the companies. A typical example of this is lease finance. Various companies take recourse to lease financing for items such as plant and machinery, vehicles, office equipment, etc. The lease finance taken is not entered in the books although the periodic lease rental is charged off in the profit and loss account of the company. CRISIL incorporates the outstanding principal portion of such lease liabilities into its total debt computation.

Financial Guarantees CRISIL also looks at financial guarantees provided by a company for loans taken by group companies. Often, it is seen that small companies do not have access to funds on their own or are only able to access funds at high rates. Such companies take the recourse of obtaining guarantees from a strong company (usually within the group) which assures of financial support in case of exigency. The analysis adopted by CRISIL looks at the possibility of this guarantee being invoked and the likely impact of honouring the guarantee obligations on the financial position of the company.

Tangible Networth

The formula used for networth calculation is as follows: Networth = Equity Capital + Reserves and Surpluses

Aside from share capital and share application money CRISIL considers as quasi equity certain debt instruments which are expected to be converted into equity at a prespecified date. Examples of such instruments are fully convertible debentures (converted within 12 months), cumulative convertible preference shares, etc.

Reserves and surpluses comprise of capital reserve including cash and non cash items such as capital subsidy, amalgamation reserve, share premium reserve, general reserve and other free reserves.

The sum of equity and reserves are set off against intangible of the company such as miscellaneous expenditure, account, etc. Also excluded from the networth calculation by CRISIL is the revaluation reserve since the reserve does not signify any actual increase in tangible asset of the company.

Adjusted Networth

CRISIL believes that the networth calculated as above does not always reflect the true size of the company’s owned funds. This is because some companies have sunk investments on their asset side, examples of which are given below. Such investments are set off against the networth of the company to arrive at the adjusted networth.

· Sunk investment / loans to affiliate companies / subsidiary companies : Some companies have investments and exposure in their subsidiaries and other group companies. An investment or a loan is treated as sunk if the chances of it generating returns or even a recovery are negligible.

· Circular investments : Some companies undertake cross holdings in order to bolster their networth. This happens when one company has an investment in another company who in turn invests it back into the equity capital of the original company. Since this is an artificial boosting of both the companies’ networth, the investment amount is netted off from the networth of each of the companies. · Any unprovided losses or provisions are also adjusted against the networth of the company.

Importance of gearing

The gearing level of a company is determined by its funding mix, which is generally a choice of the management of the company. In effect, gearing denotes the extent of financial risk taken by a company. Although a high dependence on borrowed funds (and thus high gearing level) may result in higher shareholder value, it translates into a high fixed cost in terms of interest burden and this adversely affects the financial position. In fact, in situations of weak business performance of a company, a high gearing aggravates the dete rioration in profitability as well as puts pressure on the repayment ability for its various debt obligations. This is pertinent in the case of cyclical industries which are characterised by high business risks and cannot afford to have a high gearing level. Since the purpose of rating is investor protection by way of reflecting the ability of companies to ensure timely fulfilment of debt obligations, a high gearing has an adverse impact on the rating of the company.

As has been mentioned earlier in this article, a final rating given to a company is a summary of its business and financial risk. In the context of financial risk evaluation, CRISIL expects gearing levels to be in specified bands for various rating categories. For instance, the expected gearing level for a AAA rated company would typically be 0.5, 1.0 for AA, 1.5 for A and less than 2 for the BBB category. These benchmarks are not meant to be precise but are intended to convey ranges that characterise levels of credit quality as represented by rating categories. In other words, the above correlation does not mean that a company with a gearing less than 0.5 will always get a AAA rating just as it does not imply that a company having a gearing higher than 0.5 will never be qualified to get a AAA rating. Moreover, strengths evidenced in one financial measure can offset, or balance, relative weakness in another.