The corporate debt market has been booming, although the types of bonds companies sell have seen a real change. But whether companies decide to issue debt or not depends on more than just capital markets conditions. According to AFP research published in the CTC Guide to Capital Structure, companies typically consider the following factors when making the decision to leverage their balance sheet:
- Business needs
- Financial risk
- Refinancing risk
- Capital market risk
- Buyback appetite
- Management philosophy.
What treasurers can do
Based on extensive interviews with practitioners, AFP has identified the following steps treasurers can take to help guide management toward the right capital structure decisions:
1. Start by looking at your company’s needs for capital. Capital structure is driven by the firm’s need for capital and its business strategy. When looking at capital allocation consider the following factors:
- Organic growth
- Returning cash to shareholders.
2. Consider the amount of minimum liquidity required to finance these needs. This will determine the construction of your company’s balance sheet. Many companies calculate a basic amount of liquidity they require, including access to contingent capital such as bank lines, capital markets (term debt, convertibles and commercial paper).
3. Run this liquidity level through “what if” shock scenarios. For example, what would happen if there was a 20-30 percent drop in business activity (assuming still positive cash flow)? Use the stress test to arrive at a final liquidity figure.
4. Decide whether there is an optimal credit rating that would guarantee your company access to the capital markets should the need for additional liquidity arise. Maintain the balance sheet required to keep the desired rating. Work with rating agencies to define financial ratios and discuss capital planning. Remember—the fewer surprises the better. The credit rating is not important in itself; it is the access it provides that matters. Investment grade companies have a lot more flexibility using tier-1 CP markets, for example, even if their “optimal” capital structure in terms of minimizing WACC is BBB.
5. Consider the following factors as they relate to your organization:
- Business risk, i.e., is your company in a volatile business that has unexpected cash flow needs and faces potential threats from competitors? If so, your company may need a bigger liquidity cushion even if that means a suboptimal WACC.
- Financial risk, i.e., does your company have enough cash and cash equivalent on hand to handle operations, growth and potential acquisitions? If not, can it easily access such funds?
- If access to additional funds is nonexistent, what structure does your company need to put in place to create the financial flexibility its business requires?
- What are the needs of the various constituents within the capital structure universe— shareholders, bondholders and employees?
6. Consider how to maximize firm value through earnings per share or cash flow per share. As the perception of risk in the company drops, valuation rises—increasing value to shareholders.
7. Come up with a clearly defined decision-making framework to share with the board and senior management that could guide specific liquidity scenarios. Having a framework puts discipline around the process and shows management that treasury is thoughtful and methodical rather than arbitrary in its decision-making process. Having a framework also means that capital structure decisions are not made on the fly as market conditions change but within the context of the company’s business and capital allocation needs.
8. Run this framework by industry peers to see what others are doing. “You don’t want to be an outlier,” as one treasurer put it.
9. Educate others within treasury as well as finance partners like tax. It’s important to get everyone in the organization to buy into the framework so that the company follows a cohesive path as its goes through business cycles.
10. Get buy-in from the board.
11. Issue debt considering market conditions. Tier-1 CP may be the cheapest alternative and has proven a reliable source of funding even in times of crisis, but it has limited capacity and carries refinancing risk. Market conditions are conducive to term debt, particularly for investment-grade companies. Companies worried about interest coverage ratios may choose converts instead. Don’t issue debt unless your company has a use for the funds. Issuing at 2 percent sounds great but sitting on cash earning 20 bps burns a hole in the balance sheet.
12. Finally, decide how to return excess cash to shareholders: There are arguments on both sides including tax benefits and flexibility. Many of them tilt the scales in favor of buybacks.
Download the CTC Guide to Capital Structure here.