Rethinking Capital Structure Series
(Part 1)

This article is the first of a new series called “Rethinking Capital Structure.” In this series, we will explore risk management best practices in relation to corporates’ capital structure. Capital structure is of strategic importance as it ultimately affects a company’s ability to raise capital and make profitable investments in the future. A capital structure with unmitigated risks may result in inefficiency as it could be under-valued by investors or perceived as too risky by debtors.. This should therefore be an area of focus for treasurers and CFOs alike.

In this article, we discuss a few popular financial metrics that can be impacted by noise from financial markets. In a perfect world, hedging would be able to cancel all noise on all metrics. However, in the real world this is seldom possible and companies must prioritise and compromise.

What is the right metric?

A few popular financial metrics that companies typically target:

Leverage ratios (quantum of debt measured in relation to assets or earnings):

• Debt / assets (or equity)
• Debt / EBITDA (or cash flows)

Business risk (margins inherent in the underlying business):

• Gross margin or Operating profit margin

Interest coverage ratios (serviceability of debt):

• EBITDA / Interest expense

Other valuation-related metrics (could be important for M&A):

• Net asset value
• Tangible net worth

However, some of these metrics can sometimes contradict one another.

For example, if we focus on the leverage ratios for a multi-national corporate, since both ratios (debt-to-assets and debt-to-EBITDA) use “debt” as the numerator, adjusting the currency composition of your debt to stabilise one ratio could de-stabilise the other, as could be seen in the illustration below.

Consider a USD-denominated company with equal split in assets between EUR and USD. The EUR asset is expected to yield 10 per cent p.a. in EBITDA and the USD asset is expected to yield 15 per cent p.a. in EBITDA. Right now, the company has an initial debt to asset ratio of 50 per cent. How should the treasurer allocate the debt amount between the two currencies to minimise FX volatility?

There are two options below.

Stress testing the EUR movements against USD, we see that the two ratios (Debt/EBITDA and Debt/Asset) cannot be stabilised at the same time.

In fact, it is a mathematical impossibility to stabilise both ratios if the currency composition of your assets and earnings are in different proportions. In fact, this is quite often the case, as different assets generally have different yields, especially in a diverse portfolio with both developed and emerging market exposures.

“Natural hedging” by balancing the amounts of debt held in each currency can therefore only be done once a decision has been made as to which metric is a priority.

Real-life analogy: Noise-cancelling headphones

This is similar to an engineer tasked with calibrating a noise-cancelling headphone.

Noise-cancelling headphones work by having a hidden microphone which collects the background noise, analyses and then inverts it. By emitting a “counter-noise” they act to neutralise the unwanted sound.

Anyone who has used such devices might know that it only works for low-frequency noises such as engine noise from the aircraft or motor vehicles, not higher-frequency ones, such as other people’s chatter. Sometimes, annoyingly, the analyser can even actually amplify those other noises.

Just as the sound engineer can presumably only calibrate the noise-cancelling device to invert one but not both types of noise, a treasurer may only be able to calibrate their company’s debt to “invert” either its asset or earnings portfolio.

Graph 1 and 2: The counter-noise only works for one type of noise!

What if more than one ratios are just as important? Can there be a multiple mandate?

The capital structure that results in the least volatility for one ratio may sometimes increase the volatility of another. If multiple ratios are deemed equally important, optimisation analysis can be carried out to find the hedging strategy that can minimise the collective volatility in these ratios.

Key Takeaway for CFOs and Treasurers: A two-step approach to risk management

Defining an effective risk management strategy to de-risk a company’s capital structure is not straightforward. Firstly, the most important KPIs (key performance indicators) for the company must be identified and the potential impact of market moves on these quantified.

Targeting one metric may lead to an adverse impact on another so there may be a need to compromise and/or utilise more sophisticated hedging strategies over and above the simple natural hedge approach. A combination of the right funding mix and derivatives can be engineered to reduce risk to the corporate structure and potentially increase shareholder value.

HSBC's Thought Leadership team has dedicated expertise to help companies optimise the risk management of their capital structure.