Debt has been an integral part of any business to grow and sustain itself. Some consider it as a necessary evil that needs to be managed carefully. It is not just about the five Cs — character, capacity, conditions, capital and collateral — that corporates need to provide for.
They need to ascertain whether the business model can provide for debt obligation — not just the interest outgo but the principal, too. Most companies and their financial controllers are driven by debt-equity ratios and receivables while arranging for working capital needs.
It is under stable conditions that these provide some guiding principles to a company’s management, its board of directors and banks. But these are not the only indicators to look at while soliciting debt to support businesses.
The adequate utilisation of leverage can yield a higher return on capital, but mismanagement and over-borrowing can lead to challenges. Operating cash flows, total debt to EBITDA (earnings before interest, tax, depreciation and amortisation) margins, and working capital trends are some of the critical indicators to examine the maximum debt levels a company should borrow.
Banks while considering credit risks usually focus on standard guidelines such as Basel III norms. Their risk teams also use credit risk predictive modelling tools and other indicators to assess a business’s credit worthiness.
However, these need to be reviewed in line with the borrowing company’s business model and depending on its size, capital intensity and other dynamics to develop a more comprehensive debt model. For instance, long-term debt instalments and debt servicing costs need to be directly connected to operating cash flows and must adequately provide for overheads and one-month cash reserves for emergencies.
Free cash flows
Secondly, the quantum of debt must be proportionate to profitability as anything more than three times EBIDTA must not be considered, especially in the SME sector. It is essential for any chief financial officer to watch debt servicing costs continuously. At any stage, it must not exceed 1.5 per cent of the top-line and 15-20 per cent of EBITDA.
This needs to be a gospel for any low capital intensity businesses with single-digit EBIDTA margins. Free cash flows are for sure critical to the business, but additional liquidity inflows derived from debt must not be encouraged unless its impact on the business model is understood. It should not be about creditworthiness alone but real business needs.
Adequate debt levels must be ascertained based on cost and the business’s ability to pay for this debt through internal resources. The structuring of the debt facility also plays a role in the impact it can have on business.
An efficiently structured facility allows for the utilisation of funds on a need-to basis and avoids burdening the company by having to borrow upfront or pay huge set-up fees. This facility eventually increases the effective rate of debt financing.
A company’s equity must provide for overheads, the share in capital costs and any working capital gaps net of its receivables financing as a general rule. It is not encouraged that companies seek debts to fund their overheads and capital costs unless it is project-driven. When looking at a healthy company’s financials, project profitability must be evaluated for net returns after considering receivables financing for working capital needs and any capital or long-term loans costs.
Tariq Chauhan is Group CEO at EFS Facilities Services Group.