Chapter 39
CAPITAL STRUCTURE POLICIES : Implementing a debt policy
Once a financial structure has been chosen, the task of the treasurer is to reduce the cost of debt, while retaining as much flexibility as possible.
To manage the company’s net debt and raise funds in line with the main items on the cash flow budget, the treasurer can:
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use the assets on the balance sheet or not;
- negotiate OTC products with banks or tap the financial markets.
Bank financing is a question of negotiation and intermediation, whereas primary market financing is governed by market forces. The choice for SMEs between bank financing and tapping the markets is a theoretical one, given that bank financing is in a much stronger position and due to the virtual impossibility of SMEs being able to use market products, given their size.
Using collateral definitely reduces the cost of a loan and may sometimes allow a company to obtain financing that it could not get based only on its intrinsic qualities. Using collateral makes it possible to isolate the various economic risks.
Legal or contractual provisions may rank certain creditors behind chirographic creditors, thus making them “subordinated creditors”. This means that if the company is wound up, they are paid after the preferred creditors (who have access to a specific guarantee), and after the chirographic creditors (these two categories of creditors being “senior” in comparison with the subordinated creditors), but before the shareholders. In exchange for taking on a greater risk, subordinated creditors demand a higher interest rate than the holders of less risky debt, in particular the senior creditors.
Other important debt parameters include the type of interest rate, fixed or floating, the choice of which depends, often wrongly, on the financial director’s expectations of what interest rates are going to do.
Once a bank debt has been contracted, it is quite often renegotiated. This is because either the company, having improved its financial situation, wishes to reduce the cost of its debt or to modify the duration, or because it is forced to do so because it has failed to comply with the covenants.
A good debt policy is a policy that leaves cash on the balance sheet in order to be able to deal with the unexpected and to reduce risk, to reassure the company’s partners and to enable it to seize investment opportunities.
Finally, the financial director would be advised to have close relationships with a limited number of banks to diversify the company’s sources of financing among the different providers of debt, to adapt the maturity of debts to the likely profile of cash flows, and to agree to covenants and asset-backed financings very cautiously, in order to retain as much room for manoeuvre as possible.