Managing balance sheet debt for corporates
We hope you’re all enjoying the sunny weather we’re having at the moment, and while many of us may be spending time outside, the more studious of you will still […]
We hope you’re all enjoying the sunny weather we’re having at the moment, and while many of us may be spending time outside, the more studious of you will still be learning and working. So, for those who are keen to do some learning on their break today, here’s a piece on how corporates can approach the management of balance sheet debt.
Approaches to debt management
Managing the level of debt (or leverage) on the balance sheet is important to any corporate’s capital structure and risk management strategy, impacting: credit rating and the ensuing cost and availability of borrowing; compliance with bank and lender covenants; the cost of equity through optimising WACC (weighted average cost of capital) and increasing the stability of earnings; support for long-term client and supplier relationships and instilling greater investor confidence in management.
Targeting a level of balance sheet leverage is a core strategic decision and managing it successfully has a significant impact on the level of shareholder returns. Traditionally, multinational corporates borrow against the fair value of assets, where protecting the value of longer-term capital intensive investments is the strategic risk objective. Alternatively, some borrow against future cash flows or earnings (often EBITDA) where the business is ‘asset light’ and shareholder value is more closely linked to cash flow generation.
Risks
Re-translation risk within the first approach is relatively straightforward, as the closing exchange rate for the reporting period is used to translate both overseas assets and debt into the functional currency. If the effective currency of its borrowings has been aligned and the cash flow plan followed, the fair (or book) value of its assets relative to debt will be protected.
Borrowing against future cash flows, however, poses a more interesting problem as cash flows or earnings are translated at the average exchange rate for the period, whereas debt is translated at the closing rate. The different exchange rates used to re-translate the two inputs into the leverage ratio can cause difficulties: the average exchange rate used for cash flow earnings translation is significantly less volatile within an annual reporting period than the closing exchange rate used to re-translate foreign currency denominated debt.
Planning and modelling
There should be a plan for CAPEX, M&A and dividends in conjunction with an operating cash flow plan and closing leverage target for the period. But how to minimise the effect of exchange movements upon the reported leverage ratio by adjusting the effective currency of the debt portfolio? The exposure in this situation is the impact arising from the average and closing exchange rates being different from the expected exchange rate.
A crude real-world model might have exchange rates moving away from the expected rate by an increment of 10% every six months. Debt therefore is exposed to FX impacts of between 80-120% of its expected value over the course of a financial year. EBITDA however, translated at average rates, is only exposed to a range of 90-110%. See a potential problem?
One suggestion is to hold less currency debt by proportion to that of the corporate’s earnings. If the exchange rate used to translate debt can move twice as much as the rate used for EBITDA, then carrying half this proportion of debt compared to EBITDA matches the overall exposure. This produces a lower risk from exchange rate changes to the leverage ratio compared to the traditional approach.
Clearly across the infinite range of exchange rate scenarios that can play out over the course of a reporting period alternative debt portfolios may under or over perform versus others. However, this approach allows for meaningful analysis of exchange rate risk to balance sheet leverage.
Understanding the risk and the tools available to manage it allows management to make informed decisions, which, over time, should produce a more stable and targeted reported leverage ratio and benefit the creation of shareholder value.
For those of you yet to cover this topic in your studies, there’s a whole lot of fun to come!
Enjoy the sunshine (while it lasts!)
