71 / 72
risks ȋincluding industry-
speciic characteristics,
for example, change in
competitive dynamicsȌ, as
well as the macroeconomic
environment. The treasurerǯs
strategic business partners,
such as relationship banks,
will be able to assist in
building this out.
From those future cash
lows, it is then possible to
determine how much debt
the company could, in theory,
aford and, in turn, how much
equity should be in place.
Once the base case is
determined, it is advisable
scenario analyses. This
means stress-testing key
cash-low drivers, such as
operating proits, interest
rates, FX rates, working
capital, capital investments
and other growth initiatives
– which can be impacted by
business or inancial market
conditions. The key is to
stress-test for both in a way
that is consistent with the
speciic challenges faced by
the business. Take a Europe-
based airline business as
an example. )f there is a
signiicant move in the £/$
exchange rate, then not only
will the jet fuel price change,
since commodities are priced
in dollars, but customer
demand characteristics are
likely to change accordingly.
This means that a single
event in the FX market could
have a double impact on
the business.
Taking into account all
the diferent risk factors that
could afect the companyǯs
proit margins and cash lows
in this way helps determine
whether the proposed capital
structure ȋresulting from
the Ǯafordability testǯȌ is still
functional and afordable.
)n other words, does the debt/
equity mix need to provide
a funding strategy-driven
necessity. While that is
absolutely the companyǯs
prerogative, it is important to
formally recognise this when
setting the parameters of the
optimal capital structure.
After all, credit ratings
can open doors to investorsǯ
money. While investment-
grade companies generally
ind good market access
through the cycle, being
sub-investment grade does
not preclude an issuer from
inding liquidity. The size
of the debt inancing that
the company needs to raise
and the market conditions
at the time of issuance also
play an important role.
Over time, many companies
have successfully tapped
alternative funding sources,
such as private placements,
unrated bonds and loans, as
well as hybrid instruments.
Moreover, it is not only the
inancial proile or balance
sheet structure of a particular
company that determines the
quality of its credit proile; it
is the interplay between the
industry dynamics, business
model and balance sheet.
So while credit ratings are
important, they should not
necessarily be perceived as
the be-all and end-all.
A forward-
looking approach
With so many considerations
to take into account, how
then can a company put
all of this into practice
to implement an optimal
capital structure?
The answer: by taking
a forward-looking view.
The irst step here is to build
a base case for afordability,
which means determining
the expected future cash
lows of the company. This
should relect the operating
environment and business
capital structure and
afordability levels, it is
vital to leave headroom
to absorb the impact of
any unwanted internal or
external events – such as
operational challenges or
– on cash lows and proit
margins. This provides a
safety barrier that is more
eicient than holding
a stockpile of cash.
͟. Liquidity.
Given the
uncertain world in which
treasurers operate, it
is important to ensure
that the company can
tap diferent markets for
liquidity as and when
required. (aving access to
a broad funding toolkit will
assist greatly in achieving
the optimal capital
structure and, indeed, for
adjusting it over time. )n
addition, the broader the
access to liquidity, the more
routes that are available
some routes to market.
Conducting a thorough
review of the companyǯs
existing capital structure with
a view to optimising it also
means questioning the status
quo. )s a large cash bufer
really required any more?
)s it in fact causing a drag
on the eiciency of the
capital structure?
Another area where
corporates may want to do
some soul-searching is credit
ratings. For some companies,
one of the main objectives of
an optimal capital structure
is to maintain a target credit
rating, which grants them
access to their optimal level of
capital market liquidity. For
other companies, though, the
credit-rating target is more
of a cultural or philosophical
level that the company likes
to maintain, rather than
Christian Leibl
(left) is head of
capital structure advisory; and
Yuri Polyakov
(right) is head of
financial risk advisory at Lloyds
Banking Group
With so many considerations to take into account,
how then can a company put all of this into practice
to implement an optimal capital structure?
adequate headroom – or to
maximise eiciency?
Stress-testing also provides
an opportunity to consider
how the optimal capital
structure will tally with the
companyǯs risk management
strategy, and vice versa. (ow
can the treasurer better
manage any of the scenario
stresses in order to increase
cash-low visibility and
reduce cash-low volatility, for
example? Treasurers should
also take into account how
risk management techniques
may impact the optimal
capital structure.
Time to review
Once all of these
considerations have been
factored in, the treasurer
can set about implementing
the capital structure that
has been determined as
optimal. But part of taking
a forward-looking view also
means recognising that
this is a moving concept –
and, as such, it needs to be
monitored, reviewed and
adjusted from time to time.
A simple rule of thumb here
is that if the companyǯs cash
lows change by more than
͜͝% from one year to the next,
then it is time to revisit your
capital structure and risk
management strategy.
And whenever you
undertake this review,
regardless of the companyǯs
credit rating or industry
sector, the guiding principles
should always be: eiciency,
lexibility and liquidity.
IAFEI Quarterly | Issue 31 | 69