INTM517110 - Thin capitalisation: practical guidance: measuring debt: example: the components of a debt: equity ratio calculation
Whether or not a debt:equity ratio is intended to form part of the thin cap agreement, the relative proportions of debt and equity must, nevertheless, be considered.
The definition of debt for this purpose can be found in INTM517020, the definition of equity in INTM517030, and the definition of debt:equity ratio is:
The ratio of the total interest-bearing debt to the shareholders’ funds (equity)
| - | Note | 20X0 |
|---|---|---|
| - | - | £m |
| Creditors due within one year | - | - |
| Bank overdrafts | 1 | 3.5 |
| Loans from group undertakings | 2 | 10.0 |
| Trade creditors | 3 | 1.3 |
| Other creditors | - | 0.4 |
| Creditors due after more than one year | - | - |
| Bank loans | 4 | 4.5 |
| Loans from group undertakings | 5 | 75.0 |
| Debentures loans | 6 | 10.0 |
| Share capital and reserves | - | - |
| Called up share capital | - | 2.0 |
| Share premium account | - | 0.5 |
| Capital redemption reserve | - | 1.2 |
| Revaluation reserve | 7 | 0.8 |
| Capital contribution | - | 1.0 |
| Profit and loss account | - | 21.3 |
Notes:
- The bank overdraft was granted to assist cash flow. The company has had a significant overdraft for each of the past four years.
- The loans from group undertakings are interest-bearing except for a £1m interest free loan from the parent company. The interest-bearing loans from group undertakings that are falling due within one year of £10m are repayable on demand, though relevant entities have confirmed no repayment will be demanded for at least one year.
- No trade creditor is over 60 days.
- The bank loan has a fixed rate of interest and was made three years ago to assist with a property purchase. It is repayable in full at the end of 20X3.
- Floating rate loan from parent, made during the last accounting period.
- The debenture loan is repayable at the end of ten years. The loan was issued at a discount so when the repayment is made the effective interest rate over the ten years is 5% per year.
- Company property is revalued every three years by independent valuers. Between these dates, company property is revalued by the directors. The revaluation of reserve of £0.8m consists of a revaluation of £0.5m following the conclusion of an independent valuation conducted two years ago, and a directors’ estimate of £0.3m.
It is possible that not all the information given in the notes above will be available at the time a debt:equity ratio calculation is being made, in which case several possible ratios may emerge, but based on the information given, the calculation might proceed as follows:
Debt:
- Bank overdraft of £3.5m: the information provided indicates this is a component of the capital structure of the company rather than a short term facility, so it ought to be included in the calculation of interest-bearing debt: include £3.5m.
- Loans from group undertakings of £10m: since the interest-bearing loans are expected to continue beyond the year, they should be included in the calculation of debt. The £1m interest-free loan is due to be repaid soon, so it should not be included in either the debt or the equity calculations: include £9m. (HMRC should query why interest-free debt was being repaid before interest-bearing debt. Interest free debt is akin to equity, and debt is repaid before equity)
- Trade creditors of £1.3m: trade creditors are excluded because they have not been outstanding long enough to become interest-bearing.
- Other creditors of £0.4m: there is no information about this item, but it is unlikely this creditor is interest-bearing, and in any case, this balance is unlikely to have a material impact on the calculation: include £nil.
- Bank loans of £4.5m: this is (presumably) arm’s length interest-bearing debt: include £4.5m.
- Loans from group undertakings of £75m: this is interest-bearing debt: include £75m.
- Debentures loans of £10m: this was issued at a discount though interest is effectively accruing at 5% per annum over the term of the loan. This would not be ignored by a third party lender: include £10m.
Total debt: £102m (£3.5m+£9m+£4.5m+£75m+£10m)
Equity:
- Called up share capital of £2m: this is clearly equity: include £2m.
- Share premium account of £0.5m: since this comprises funds paid for shares above the par value, it is part of the shareholders’ funds: include £0.5m.
- Capital redemption reserve of £1.2m: This comprises profits set aside to redeem share capital, and is therefore part of shareholders’ funds: include £1.2m
- Revaluation reserve £0.8m: only £0.5m of this reserve is independently verified. The £0.3m revaluation adjustment made by the directors should initially be ignored, though this point should be reconsidered if evidence is provided that this further valuation adjustment is appropriate: include £0.5m.
- Capital contribution of £1m: if this is a genuine capital contribution (see INTM503050) it may be included in the calculation of equity: include £1m. Uncertainty can be satisfied by a condition in the agreement that the capital contribution will remain in place for the duration of the agreement.
- Profit and loss account of £21.3m: This is the normal accumulated profit transferred to reserves, making it part of the shareholders’ funds: include £21.25m
Total equity: £26.8m (£2m+£0.5m+£1.2m+£0.8m+£1m+£21.3m)
Thus, the debt:equity ratio for 20X0 works out at £102.0m/£26.8m = 3.8. This is very high, and in the absence of special circumstances it would be treated as excessive.