Practical capital insights for treasury

Practical Capital Insights for Treasury

Capital is one of the most important and wide-ranging concepts in treasury. James Leather FCT AdvDipTM, Corium Treasury advises accordingly to always ensure common understanding of definitions:

"Time invested to understand what is meant by ‘capital’ will be well spent.  For some it means debt and equity, for others, there is a narrow regulatory definition, which focuses on capital as 'equity'. Don't embark on any capital project, before ensuring that everyone involved, has the same understanding." 

 

How to add value

In the regulated context – mainly banks and other financial services firms – treasurers need to master detailed pre-specified regulatory definitions of capital. 

For non-financial corporates seeking to optimise our weighted average cost of capital, the relevant measures are the current market values of our organisation’s equity and debt. 

Invest time into your personal understanding of capital, and you will greatly enhance the value you can add to your organisation.

 

Four perspectives of capital

Capital has a wide range of definitions, depending on the detailed context. For example, capital may include financial resources, capital goods such as transport infrastructure, and human capital including knowledge, skills and relationships.

From a treasury perspective we will consider the following perspectives on capital: (1) Equity capital in regulation, law and financial reporting; (2) Debt plus equity in corporate finance; (3) Working capital management; and (4) Other forms of capital.

 

(1) Equity capital in regulation, law and financial reporting

Regulation, law and financial reporting are all grounded in – or framed around – the concept of equity.

 

What is equity?

In financial reporting, equity capital is money the reporting entity owes to its shareholders or other owners. This is equal to its total assets minus its total liabilities (including debt). This figure is also known as Net assets or Equity.

In this context equity capital is viewed as funding the net assets of the organisation.

Equity capital also acts as a buffer to absorb losses or other deficits, to support the business to continue its operations following financial stress. For this reason, regulation and law also look to the organisation’s equity as the foundation of its concepts of Loss absorbing capacity and Capital conservation.

 

Regulatory capital – prudential regulation

Regulatory capital applies primarily to banks and other financial institutions including building societies and insurance companies. 

Regulations and related supervision specify minimum mandatory amounts for the regulated firm’s equity capital, held for the protection of direct stakeholders and the wider community. The idea is that the regulated firm maintains a minimum Loss absorbing capacity (LAC) to enable it to survive losses and other financial stresses.

This is an aspect of the prudential regulation of the financial sector, undertaken for example in the UK by the Prudential Regulation Authority (PRA).

Regulatory capital is a constraint and source of cost for the regulated bank or other firm. Therefore it directly affects the bank or other firm’s appetite and pricing for providing financial services. Non-financial organisations’ corporate treasurers need to be aware of this, as customers of regulated banks.

In the regulatory capital context, 'capital' means what the particular detailed regulations say that it means, applied and interpreted in the context of the regulated firm.  Here as elsewhere, care and consistency in definitions and understanding is essential.

 

Company law – capital conservation

More narrowly in company law, 'capital' is the component of total equity represented by the share capital of the company. Companies are strictly limited in the uses to which they can apply their share capital. This principle is also known as Capital maintenance, and it is designed for the protection of the company’s creditors and potential creditors.

 

(2) Debt plus equity in corporate finance – cost of capital

More broadly in the corporate finance context, 'capital' is the total amount of funding available to support the operations of an organisation. This includes both its debt liabilities and its equity.

 

Weighted average cost of capital (WACC)

The WACC is the average percentage cost of capital of a firm, taking into account:

(a) All sources of capital

(b) Weighted by their current market values.

 

WACC calculations

For a firm with both equity and debt capital, the WACC is calculated as:

 

WACC = Ke x proportion of equity + Kd(1-t) x proportion of debt

= Ke x E/(D + E) + Kd(1 - t) x D/(D + E)

 

Where:

Ke = cost of equity.

Kd(1 -t) = after-tax cost of debt.

E = market value of equity.

D = market value of debt.

 

Example 1: Equal equity and debt

Ke = cost of equity = 8%

Kd(1-t) = after-tax cost of debt = 4%

E = market value of equity = £50m

D = market value of debt = £50m

 

WACC = Ke x E/(D + E) + Kd(1 - t) x D/(D + E)

= 8 x 50/(50 + 50) + 4 x 50/(50 + 50)

= 8 x 50/100 + 4 x 50/100

= 8 x 1/2 + 4 x 1/2

= 4 + 2

= 6%

 

This weighted average of 6% is exactly mid-way between the cost of equity (8%) and the after-tax cost of debt (4%), because the proportions of equity and debt are exactly equal in this first example.

 

Example 2: Increasing equity, reducing debt

Making a number of simplifying assumptions, if the proportion of equity were increased to 75% (= 0.75), the proportion of debt would fall to 25% and the WACC might theoretically increase.

 

Example 3: Reducing equity, increasing debt

If, on the other hand, the firm 'geared up' to reduce its proportion of equity to 25%, and increase the proportion of debt to 75%, again simplifying, the WACC might in theory fall.

In practice both the cost of equity and the cost of debt would normally change, following the changes in capital structure, leading to a more complex analysis factoring in the financial risk of debt in the capital structure.  The more debt, the more financial risk.

 

Creating shareholder value

In order to create or add shareholder value, the managers of this firm would need to earn:

  • An after-tax rate of return on their investment projects

  • Of more than the WACC - of, for example in Example 1 above, 6%.

 

In simple terms, a lower WACC will result in greater shareholder value.

 

Optimal capital structure and WACC

The optimal capital structure is therefore the most appropriate capital structure taking account of both:

  • The immediate cost saving benefits of a low WACC and

  • The potential flexibility and safety-robustness benefits of a more conservative capital structure (with a relatively lower proportion of debt finance).

 

Take a unified view

“A common mistake is to regard the fundamentals of capital allocation and capital raising as two unrelated disciplines of corporate finance. Of course your organisation will need funding to give to the spenders of the money, but the cost of capital is what drives the choices made between competing sources and applications of capital expenditure. Take a more unified view of these fundamentals to optimise your decision making.”

(Raj Gandhi, Chief Executive, GGV London)

 

(3) Working capital management – amount of capital

Follow the cash

“I think it’s important to focus on understanding the fundamental drivers of cash flow. Sources and uses of funds. Ultimately cash is the lifeblood of the business. It is imperative to be able to smell and follow the cash trail.”

(André Khor, Group Chief Financial Officer & Deputy Chief Executive Officer, PT Chandra Asri Pacific Tbk)

 

Working capital

Working capital is normally defined broadly as the excess of current assets (excluding cash) over current liabilities. It represents the day to day capital requirement to continue the operations of the organisation.

This working capital requirement has to be financed in some way, or usually a combination of different ways.

The lower the working capital, the lower the organisation’s capital requirement and the lower its £ cost of servicing capital providers.

 

Compromise

However, there are practical, operational and commercial limitations on how low working capital levels can fall without adversely affecting operations and relationships.

As a result, the management of working capital is essentially a compromise between levels high enough for smooth commercial operation and safeguarding reputation, and levels low enough to be financially efficient.

 

(4) Other forms of capital

Economics

'Capital' is one of the 'factors of production' in classical economics. In this context, 'capital' traditionally referred to things that have been created to help in the production process, like machinery, factories and transport facilities. These things are sometimes known as 'capital goods', or ‘manufactured capital’.

In modern economics, human capital, natural capital and social capital are additional and fundamentally important dimensions of capital, relevant for treasurers to understand, maintain and grow.

 

Human capital

Human capital includes the knowledge and skills of individuals, and also related groups of people including employees.

 

Natural capital

Natural capital can be defined as the world’s stocks of natural assets which include geology, soil, air, water and all living things. Examples include global forests and their role in controlling greenhouse gases, insects as pollinators, water resources and the ecosystems of the planet. 

 

Social capital

Social capital means the valuable relationships between people. For example, between people who work together or live together, as well as the knowledge and skills they have between them that they share with each other.

 

Grow your human capital

Congratulations on growing your human capital by reading this article! Your organisation and your career both benefit when you take the initiative to identify relevant opportunities and challenges like these for your personal development. 

 

 

Author: Doug Williamson FCT

 

Other resources

Practical reporting for treasurers https://learning.treasurers.org/resources/practical-reporting-for-treasurers

 

Sustainability in practice for treasury https://learning.treasurers.org/resources/sustainability-practice-treasury

 

An introduction to equity capital https://wiki.treasurers.org/wiki/An_introduction_to_equity_capital

 

An introduction to debt securities https://wiki.treasurers.org/wiki/An_introduction_to_debt_securities