This article isn't about priority, security and risk for investors, we have explored that previously. The Thames Water example above is used to highlight how complex a company balance sheet can become at scale. The range of debt, from secured short term liquidity facilities and overdrafts to long term unsecured bond issuances at Holdco levels; some inherited from previous owners; some used to fund acquisitions; some for maintenance; some for day-to-day banking; but all put in place deliberately at some stage to meet a certain purpose, deliver a strategy, or fit within certain constraints.

Capital structure is the term used to describe the mix of funding sources used by a company. This article covers the fundamentals a treasurer needs before deciding any form of financing. Debt or equity, where each instrument sits on the balance sheet. What each costs, and what security you need to give for that price. What can be sensibly financed with different kinds of capital, and the seven pairs of terms that describe almost every debt instrument you can choose without needing to read the terms.

Debt vs equity

Every asset on the left-hand side of a balance sheet is funded by something on the right-hand side.

  • Debt Money lent to the company on agreed terms. Interest, a repayment date, and remedies if either is missed.
  • Equity Money invested in the company for a share of whatever is left after everyone else has been paid. The lender's upside is capped at interest; the shareholder's is not. The lender is paid first; the shareholder is paid last, and often not at all.

Debt is cheaper than equity because it carries less risk and because, in most jurisdictions, interest is tax-deductible while dividends are not. Debt is also more dangerous, because it has to be serviced whether or not the business is having a good year. Adding debt lowers the average cost of capital and raises the probability of financial distress; the treasurer's job is to know where on that curve the company sits.

Between the two sit a wide range of hybrid instruments: preference shares, convertible bonds, subordinated notes with deferrable coupons. A convertible pays lower interest than a straight bond because the holder gets an option to become a shareholder. A hybrid bond counts partly as equity for rating purposes while remaining tax-deductible debt.

Debt against equity: the pros of debt are a lower cost of capital, no ownership dilution, interest tax deductibility, flexibility in timing capital raising, enhanced shareholder returns and retained control; its cons are debt servicing costs, leverage magnifying losses and ranking above equity. The pros of equity are permanent capital, no mandatory repayment, support for early-stage or risky businesses, loss absorption, reduced financial distress risk and supported borrowing capacity; its cons are dilution, higher required returns, potential loss of control and IPO and issuance costs. Debt against equity: the pros of debt are a lower cost of capital, no ownership dilution, interest tax deductibility, flexibility in timing capital raising, enhanced shareholder returns and retained control; its cons are debt servicing costs, leverage magnifying losses and ranking above equity. The pros of equity are permanent capital, no mandatory repayment, support for early-stage or risky businesses, loss absorption, reduced financial distress risk and supported borrowing capacity; its cons are dilution, higher required returns, potential loss of control and IPO and issuance costs.

Capital structure ranking: who gets paid first

Seniority is the order of repayment in an insolvency. The ranking runs from the first claim on the assets to the last, and risk and return both increase with every step down it.

The capital structure ranking, first paid to last, with risk and return both rising down the stack: 1 senior secured debt, a legal charge over named assets or a floating charge over the whole business, enforcing first and pricing lowest; 2 senior unsecured debt, the borrower's general promise, ranking alongside every other unsecured creditor; 3 subordinated debt, paid after senior debt by agreement in an intercreditor deed; 4 preference shares, ahead of the ordinary shares but behind every pound of debt; 5 ordinary equity, last in the queue and uncapped on the upside. The capital structure ranking, first paid to last, with risk and return both rising down the stack: 1 senior secured debt, a legal charge over named assets or a floating charge over the whole business, enforcing first and pricing lowest; 2 senior unsecured debt, the borrower's general promise, ranking alongside every other unsecured creditor; 3 subordinated debt, paid after senior debt by agreement in an intercreditor deed; 4 preference shares, ahead of the ordinary shares but behind every pound of debt; 5 ordinary equity, last in the queue and uncapped on the upside.

What you pay, and why

The cost of any instrument is a function of where it sits in the queue, what secures it, how long it lasts and how easily the provider can get out. A secured senior bank loan to a mid-market company might price at a margin of 2% to 3% over the reference rate; an unsecured term loan to the same borrower a point or so higher; subordinated or mezzanine debt somewhere in the low teens all-in, often partly paid in kind; and the equity, though nobody writes it down, will be expected to return 20%, 100% or 10x per annum depending on the stage of the equity investment.

The headline rate is never the whole cost. Arrangement fees, commitment fees on undrawn amounts, legal costs, prepayment premiums and break costs on associated hedges all belong in the comparison. Compare instruments on all-in cost over the life you actually expect, not on the first line of the term sheet.

Where instruments sit on the balance sheet

The balance sheet lists liabilities in rough order of how soon they fall due and, separately, equity. Working down from most to least liquid:

  • trade payables and accrued expenses, which are free funding from suppliers;
  • short-term borrowings, meaning overdrafts, commercial paper and any debt maturing within twelve months;
  • long-term borrowings, meaning term loans, bonds and lease liabilities; and then
  • equity, split between share capital and retained earnings.

The twelve-month line is significant. Debt that crosses into current liabilities changes the ratios your lenders and auditors read, and a facility maturing inside a year with no refinancing in hand casts major questions on stability. It is why revolving facilities are drafted as multi-year commitments even when drawn and repaid monthly: the commitment keeps the liability long-term.

Two things the balance sheet does not show cleanly.

  • Off-balance-sheet obligations Guarantees, undrawn commitments and some supply-chain finance arrangements appear in the notes rather than the numbers.
  • Ranking Two loans of equal size on the same line can have completely different claims on the assets. For that you need to go beyond the balance sheet and even the notes, and look directly at the loan documents.

What different debt can finance

Generally speaking, lenders lend against one of two broad categories; cash flow or assets.

  • Cash-flow lending Sized against the company's earnings, usually as a multiple of EBITDA, and repaid from those earnings. It funds general corporate purposes, acquisitions and growth, and it comes with covenants that test the earnings every quarter.
  • Asset-backed lending Sized against the value of specific assets, such as receivables, stock, equipment or property, and repaid from those assets or the cash they generate. It funds the assets themselves, it is available to companies whose earnings would not support a cash-flow loan, and it comes with monitoring of the collateral rather than of the P&L.

The practical rule follows: a software business with strong earnings and few hard assets borrows against cash flow. A distributor with thin margins and a warehouse full of stock and receivables borrows against assets. A capital-intensive business borrows long term against the plant and revolving against the working capital.

The seven pairs to describe your debt

Almost every debt instrument can be described by picking one side of each of the following pairs.

Secured or unsecured. Secured debt has a legal charge over specific assets, or a floating charge over everything, which the lender can enforce on default. … read more show less

Unsecured debt relies on the borrower's general promise and ranks alongside all other unsecured creditors. Security lowers the price and narrows the borrower's freedom. Once the assets have a charge registered against them, the next lender has less to lend against.

Negative pledge, where a borrower promises not to provide an asset to another lender as security, exists to protect a lender's position in an unsecured loan from being degraded by future secured borrowing.

Investment-grade corporates borrow unsecured almost entirely. Mid-market companies usually give security; the debenture in the bank's standard pack is a floating charge over the whole business. Smaller companies borrow against specific assets or cash flows.

Senior or subordinated. Seniority is the order of repayment in an insolvency. … read more show less

Senior debt is paid first, subordinated debt after it, equity last. Subordination is agreed in an intercreditor agreement, and it is the reason mezzanine debt costs three times what senior debt does.

Know what ranks ahead of you, and know what your own facilities allow to be placed ahead of you later.

Recourse or non-recourse. A recourse loan is a claim on the borrower as a whole. … read more show less

If the financed asset does not cover the debt, the lender pursues the rest of the company. A non-recourse loan is a claim on the asset alone, usually housed in a special-purpose vehicle, and the lender's only remedy is to take the asset. Project finance, some property lending and some receivables finance work this way.

The price is higher and the structuring heavier, but the trade-off is that the parent's balance sheet stays clean. Limited recourse, with a parent guarantee capped by amount or period, is the common compromise. Read the guarantee before assuming the ring-fence holds.

Short-term or long-term. Short-term debt is cheaper, more flexible and needs replacing constantly. … read more show less

Long-term debt is dearer, more rigid but gives you breathing space between refinancing. Mismatched asset and liability tenors is common in the banking world, but it's risky business. Northern Rock funded twenty-five-year mortgages three months at a time and worked beautifully until August 2007.

The treasurer's version of the rule is that the tenor of the funding should match the term of whatever it is funding, and maturities should be spread across years so that no single market event freezes the refinancing of the whole balance sheet.

Fixed or floating rate. Fixed-rate debt pays the same coupon for its life; floating-rate debt pays a margin over a reference rate, such as EURIBOR or SONIA, that resets every one, three or six months. … read more show less

The floating-rate borrower carries the rate risk, and the 2022-23 cycle, in which the ECB took its deposit rate from minus 0.5% to 4% in just over a year, moved the interest line of every unhedged floating borrower in Europe without any change in their business.

Fixing, at issue or by swapping afterwards, transfers that risk at a price, but also increases the risk of break costs if the debt is repaid early. The interest-rate risk articles cover how to decide the mix.

Amortising or bullet repayment. An amortising loan repays principal in instalments over its life; a bullet loan repays it all at maturity. … read more show less

Amortisation reduces the lender's exposure over time, which lowers the price and the refinancing risk, at the cost of a heavier cash burden in the years the business is also trying to grow.

Bullets, standard for bonds and common in leveraged loans, keep cash in the business and concentrate the whole repayment in one year. A bullet is a refinancing decision made in advance, and the maturity date is the day the market gets a vote.

Corporate-level or asset-level financing. Corporate financing is borrowing by the group against its consolidated strength: general-purpose facilities, bonds, the revolver. … read more show less

Asset-level financing is borrowing by a subsidiary or vehicle against a specific asset or pool: a property mortgage, a receivables securitisation, an aircraft lease, a project-finance loan. Asset-level debt is usually cheaper for the asset in question, because the lender is closer to the collateral, and it usually sits outside the corporate covenants.

The costs are complexity, cash trapped in the vehicle until its lenders are satisfied, and, as the Thames Water group discovered, a holding company whose only asset is shares in a subsidiary whose cash flows are already spoken for.

Describing debt with the seven pairs

Answer those seven questions, and you have most of the details you need about a financing, and it can all be conveyed in a single sentence.

  • A five-year senior secured amortising floating-rate term loan with full recourse at the operating company is the mid-market default: cheap, safe for the lender, demanding of the borrower.
  • A seven-year unsecured bullet fixed-rate bond at the parent company is what that company graduates to.

If you want the rest of the detail, there's a couple of hundred pages of loan documentation you need to digest.

The same job at three sizes

Start-up. Your options for capital structure are limited. … read more show less

Initially, equity is the only option on the table, either your own or someone else's.

As cash flow starts to arrive, so do the debt options, secured on specific revenue streams, IP or whatever assets can support them. They won't be cheap, but they will save you from raising further expensive equity capital.

Established mid-market. This is where the structure starts to become a decision. … read more show less

A secured floating-rate amortising term loan for the assets, a committed revolver for the working capital, perhaps a lease or asset-finance line at the asset level.

More decisions at signing, particularly fixed versus floating, amortisation profile and what security has been given away, can have a big bearing on the company going forward. Keep a schedule of every facility with its position in each of the seven pairs.

Large corporate. Unsecured, bullet, mostly fixed, mostly bonds. … read more show less

A syndicated revolver sits behind the commercial paper programme, and asset-level financing appears where a specific business justifies it. An IPO rewards earlier investors.

The whole structure is managed as a portfolio of maturities, fixed-to-floating ratio, secured-to-unsecured, and the ranking of every instrument against the rating agencies' view of what the group can carry.