Accounts Demystified, 6th Edition

a c c o u n t s d e m y s t i f i e d

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Back in year one it was at a fairly conservative level; currently it is over

the 50 per cent threshold at which people start to look at the company

very carefully. Let’s now see why people care about this ratio; we’ll start

by looking at it from the perspective of lenders (i.e. the banks).

Lenders’ perspective

Security of debt

When a bank lends money to a company, it is making an investment.

People and companies put their spare cash into current accounts, deposit

accounts, etc. at their banks. The banks then lend this cash to other

people and companies who need it. The banks make a profit by paying a

lower interest rate to the people depositing their money than they charge

to the people who borrow from them.

This sounds like money for old rope and it is, provided that everyone who

borrows money from the bank repays it eventually. The banks only make

a few percentage points out of each pound they lend. By the time they

have paid all their costs, their profit is a fraction of a percentage point

of the money they lend. If, therefore, someone doesn’t repay the loan, it

wipes out all the profit on hundreds of their other loans.

Figure 10.1 Wingate’s debt to total funding ratio

0%

27.6%

38.4%

48.3%

54.3%

Yr 1 Yr 2 Yr 3 Yr 4 Yr 5

59.3%

60%

20%

40%

a n a ly s i s o f t h e f u n d i n g s t r u c t u r e

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Because of this, banks always look for some security – anything that gives

them confidence that they will get their money back.

As I mentioned when we were looking at Wingate’s accounts in detail

[session 6], most companies with overdrafts or loans will have given the

bank a charge over their assets. This means that if the company goes bust,

the bank has first right to sell the assets and take the cash.

The proceeds from selling assets will not always be enough to cover the

bank’s debt if a large percentage of the funding structure is debt. Hence

the debt to total funding ratio gives an idea of the bank’s risk.

Surely the assets must always be worth more than the debt?

Not necessarily, Sarah. Remember the going concern concept. A com-

pany might buy an asset which is no use to anyone else in the world and

therefore has no resale value. We would still give this asset a value in the

company’s books, as it is of use in the company’s ongoing operations.

On top of that, a bank will only want to sell a company’s assets when the

company is effectively bust. In that situation, even assets that are of use

to other people will be hard to sell for their full value.

But presumably some of the assets, like debtors, you would get most of their book

value for, and others, like specialised machinery, you would get next to nothing for?

Of course. In practice, bankers do much more detailed checks and analy-

ses to ensure their loans are secure, but the debt to total funding ratio

does give a quick idea of the position.

Wingate’s bankers were probably told by the company’s management

that by investing in fixed assets and expanding sales rapidly, the company

could reduce its unit costs and make bumper profits. If I were a banker,

after watching the ROCE decline for four years and the debt to total fund-

ing ratio rise, I would be getting extremely sceptical by now. I would be

looking for some convincing evidence that the company’s cash flow and

return on capital were going to turn round very soon.