CFM11040 - Understanding corporate finance: raising finance: controls on borrowing

How much can a company borrow?

A company is, in theory, free to borrow whatever amount it wants to in whatever way it wants to. However, to borrow it will need to find a lender and that lender will wish to be certain that it has made a good investment, that the borrower is both able and willing to repay the debt as it falls due and pay interest and any agreed fees to the lender. Investors are unlikely to wish to invest in a company that is already heavily indebted, and will look at, among other measurements, the ratio of debt to equity finance (the ‘gearing ratio’). As a result there is a limit on what the company can, in fact, borrow. Two of the most powerful influences on the amount that a company may borrow are the non-financial factors including market risks, and the free cash flow of the company available to repay the debt.

In addition, a company which has borrowings in excess of its assets may be technically insolvent. It is illegal for a company to trade while it is insolvent. The Insolvency Act 1986 section 123 defines insolvency in terms of cash flow, i.e. the company is unable to pay its debts as they fall due, and in terms of its balance sheet i.e. the value of the company’s assets is less than the amount of its liabilities, taking into account its contingent and prospective liabilities.

Regulatory restrictions

The Financial Services and Markets Act 2000 gave statutory powers to the Financial Services Authority (FSA). FSMA 2000, in conjunction with the Companies Act 1985 and 2006, provides the framework which regulates the way in which companies and the markets operate. Certain sectors, such as banking and insurance, operate under specific regulatory rules that require them to have a certain proportion of their funding in equity.

Other rules, such as those governing membership of the stock exchange and the conduct of the members may also affect a company’s approach to raising finance, by for instance determining whether a company can have access to the markets.

CFM14000 has more on financial regulation.

Banking covenants

Banking covenants (also known, particularly in the US, as debt covenants or loan covenants) are agreements made at the time of granting a loan to a business that require the borrower to operate within certain limits. Their purpose is to impose further controls on the borrower to enable a bank to limit credit risk (CFM14100) and for example may take the form of:

  • limiting or preventing other borrowing;
  • limiting the rate of dividend that may be paid to investors;
  • requiring a certain level of interest cover to be maintained;
  • requiring that a certain level of working capital is maintained;
  • requiring the provision of regular information, for example, management accounts, audited accounts, and forecasts, within a defined timetable;
  • requiring the borrower to maintain certain balance sheet ratios;
  • restricting how borrowed funds may be used. (This is particularly pertinent for loans. The covenant is normally to be found near the beginning of a loan agreement, and separate from other covenants which regulate the later behaviour of the borrower.);
  • placing restrictions on drawdown, and on early repayment.

These obligations may be quite onerous, particularly at a time when financial institutions become more risk averse and funding may therefore be more difficult to obtain. If the borrower breaches a banking covenant, the lender is able to demand immediate repayment, although in practice it is more usual for the terms of the loan to be renegotiated or other refinancing to be arranged.