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2 Questions on capital restructuring: why you should consider capital restructure and how to get it right

Capital restructuring is a powerful tool with which to deal with changes that impact a business’s financial stability. Capital restructure also helps in rearranging capital assets to position the company to take advantage of growth opportunities and make it more appealing to investors.

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Annual financial statements consist of three major accounts namely: income statement, cash flow statement, and balance sheet. The balance sheet depicts the company’s assets against the capital used to fund them. The capital can be in the form of debt or equity. This relationship can be summed up into one simple expression dubbed the basic accounting equation: Assets = Liabilities + Equity.

How you fund your liabilities depends on several factors. The ratio of the composition of liabilities and equity is broadly referred to as the capital structure. The process of transforming the composition and magnitude of liabilities is generally termed balance sheet or capital restructuring (hereafter, restructuring).

This article addresses two questions:

  1. Why do companies restructure?
  2. what constitutes an optimal restructure?

Capital restructuring: understanding capital is key to appreciating capital restructure

To better appreciate the relevance of restructuring one should understand the nature of debt and equity funding, the two main sources of capital. Equity capital is residual ownership of a company. It is low ranking in claim to the assets of the company in contrast to debt. Given its residual claim, equity capital providers consider it relatively high risk. As such, the cost of equity capital is higher than that of debt, true to the adage “high-risk, high returns”. Which in all accuracy should be “high-risk, high expected returns”. Capital providers require higher compensation for equity.

Debt capital mainly results from a contract between the creditor and the business. This could be a bank, individual investor, etc. Debt contracts are either long-term or short-term, both categories attract interest costs. Interest paid by the borrowing business for long-term debt is usually higher than for short-term debt. In order of highest to lowest cost to the business the ranking is; equity, long-term debt, and short-term debt. Armed with this knowledge, we can explore the two questions identified.

Capital restructuring: why should you look at capital restructure?

Three strong reasons exist to support the case for capital restructuring:
  • To improve the serviceability of current outstanding debt, cashflow management. One can convert an amortising loan into a balloon payment in line with their cash flow expectations. A business may engage in such a restructuring when the business expects low free cash flow in the near term but a cash waterfall at a given future date.
  • To fund expansion endeavours. Depending on the risk profile of the expansion being taken, a business may grapple with the type of funding to be used. For example, if a company wants to scale up production and they seek to invest in infrastructure to support the endeavour, it may add long-term debt or equity in its capital structure. In an alternate scenario, if the company wants to increase production temporarily, it may choose to add short-term debt into its capital structure to support working capital. The “why” greatly influences the how.
  • To leverage or deleverage given the interest rate cycle to optimise return on investment. In a high-interest rate environment, a business would want to deleverage to reduce finance costs and vice-versa when interest rates are declining.

Optimal capital restructuring: getting capital restructure right

An optimal restructure can be measured in two ways; a change in the weighted cost of capital (WACC) and a change in Debt-service-coverage-ratio. Weighted cost of capital is the average cost of capital from debt and equity, adjusted for their respective weights in the capital structure. Debt-service-coverage-ratio (DSCR) is the ratio of cash flow to debt service (interest plus loan repayment). Cash flow may be proxied by cash flow from operations (CFO) or earnings before interest tax depreciation and amortisation (EBIDTA).

An improvement in the WACC of a company may be observed in its reduction (negative change). This can be achieved by acquiring more debt in the capital structure. Further improvements can be made through a further tilt towards short-term debt. It is worth noting, however, the choice of the debt instrument is also influenced by the reasons underpinning the restructure.

Another way to assess the extent to which the restructuring decision is optimal is to look at the increase in DSCR. An improved DSCR indicates that the business has improved its ability to pay the interest and principal outstanding as and when they fall due. For example, a DSCR can move from 1 to 1.5, this implies that the business moved from having R1 available to service R1 of currently oustanding debt, to R1.5 being available for the same. A DSCR greater than 1 is generally a positive signal. If the same falls below 1, that is a negative signal.

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Kettle consulting offers corporate finance solutions that enable you to engage in optimal restructure using the right capital instruments. We walk the mile with you and engage bankers and other funders to ensure you land a worthwhile deal. We have assisted SOEs and the private sector alike. 

Reach out and let us start the conversation. You may email us at info@kettleconsulting.co.za or call 011 025 1446 (Johannesburg) and 021 003 8000 (Cape Town)

Insight by:

prince ken nkiwane on capital restructuring

Prince Ken Nkiwane

Management Consultant

Kettle Consulting (PTY) Ltd

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