How to Analyse a Company’s Capital Structure

Reading a capital structure is a procedure, not a ratio. The separate borrowings are counted and added back to the disclosed total of Rs 6,00,00,00,000. The rates are weighted by amount to the blended 8.00 per cent. The repayment dates are laid on a line, where the Rs 3,00,00,00,000 that tranche 1 wants back as one lump when Year 5 closes becomes visible. Then what the balance sheet never showed is written down.

The procedure rests on a difference most readers never have named for them: the difference between a model and a document. In a model there is one debt line carrying one rate. In a document there is nothing of the kind. A disclosed capital structure is a set of separate contracts, each with its own amount, its own rate, its own payment frequency, its own security, its own place in the queue and its own repayment date, and the single figure printed on the balance sheet is only what survives after those contracts have been added up. Everything that decides whether a structure is fragile lives in the contracts and is destroyed by the addition. So the procedure is simply the addition run backwards: take the total apart, read each contract on its own terms, and put it back together as a ratio only at the very end.

Think of a household with three loans running at once: a housing loan with eighteen years left on it, a two-year loan on a scooter, and a card balance that is repaid and rebuilt every month. The three outstanding amounts add to one number. The single total cannot show that one loan is repaid in instalments, one is repaid in a lump, and one never really goes away. A company is the same object at a larger size, and the procedure below is what answers it.

What order do the steps run in?

Nine steps, and the order cannot be shuffled: every step feeds on what the step before it handed over. Rates cannot be weighted before the separate borrowings have been counted, a repayment line cannot be drawn before the repayment dates are known, and nothing can be called missing until all of it has been looked for. The last step is the only one whose output is a list of things that could not be found, and it is the step that separates a reading from a guess.

Step 1. Where are the borrowings, and how many of them are there?

The place to go is the note behind the borrowings line, not the borrowings line itself. The balance sheet gives a total; the note behind it gives the separate borrowings. The note is read down and each borrowing counted. The count is the first thing a total hides, and it is free to recover.

For Sankalp Industrial Systems Limited, invented, read at Year 0, the count is three. A count of three is the entire output of step 1. No rate has been read yet, no date, no security. Every step after this one is applied three times, so the number three is written down before anything else is done.

What is a tranche, and what does each one carry?

A tranche is a single borrowing, contracted on its own terms with its own lender. Each tranche was agreed with a particular lender on a particular day on particular terms, and it lives or dies on those terms regardless of what the other borrowings are doing. Every tranche carries six things, and a total borrowings figure can show exactly one of them.

The six are the amount, the rate, the payment frequency, the security, the ranking and the maturity date. Adding amounts is what the addition does, so the amount survives it. The other five do not survive it at all. Three tranches carry eighteen attributes between them, and the balance sheet reports one number.

Step 2. Do the separate borrowings add back to the disclosed total?

Add the three amounts and compare the sum with the borrowings figure on the face of the balance sheet. The reconciliation looks like bookkeeping and is not. A reconciliation that closes establishes that the note is complete; a reconciliation that does not close has just produced the most interesting finding in the reading.

The difference, if there is one, is never a rounding. The difference is a borrowing that sits somewhere the note did not cover: a lease that is being reported elsewhere, a bill discounting line that somebody classified as trade rather than debt, a loan sitting inside a subsidiaryA company another company controls, so its whole result is added into the group accounts even where part of it belongs to outside holders. whose note has not been opened. Here it closes exactly.

Step 3. Which rate is the company actually paying?

Three rates were contracted separately and none of them is the answer. One number comes from weighting each rate by the amount drawn on the tranche it belongs to, not by the count of tranches. An unweighted average of rates silently assumes every tranche is the same size, so it is always wrong.

The products are multiplied and added. Three hundred crore at 7.80 gives 2,340. Two hundred crore at 8.50 gives 1,700. One hundred crore at 7.60 gives 760. The three products sum to 4,800, and 4,800 over 600 is exactly 8.00 per cent. Averaging the three rates instead, ignoring the amounts, gives 7.9667 per cent. The two answers sit 3.3 basis points apart.

Three point three basis points is not a scandal, and that is exactly why this step is worth teaching on a case where the error is small. The error here is small because the three tranches happen to be similar in size and the rates happen to be close together. Move Rs 9,00,00,00,000 onto the cheapest of the three and the same mistake shifts the answer a very long way. The method is what is being checked, not the size of the gap in any one case.

Step 4. When does each borrowing actually fall due?

Put the repayment dates on a line and mark each amount at the date it is repayable. Do not total the line. The repayment line carries a shape, and the total the reading started from cannot carry a shape at all.

On this structure, Year 1 through Year 4 are empty apart from the annual renewal of the working capital facility. When Year 5 closes, tranche 1 wants the whole of its Rs 3,00,00,00,000 back in one payment, and the facility needs renewing inside that same year. Two years later, as Year 7 closes, tranche 2 wants its Rs 2,00,00,00,000. Flat, and then a step.

The total on its own says the company has Rs 6,00,00,00,000 of debt. The line says something completely different: this company repays almost nothing for four years and then a very large amount on a single day. Both sentences describe the same Rs 6,00,00,00,000. Only one of them says when to be paying attention.

What makes a bullet different from the same money repaid in instalments?

A bullet maturity is a repayment shape in which the entire principal becomes payable on a single date, as one payment. Nothing is repaid before it. The alternative arrangement repays principal in instalments across the life of the loan, so the outstanding amount grinds down year by year and the last payment is small.

The same rupee amount at the same rate is a different object depending on which of the two it is, and the difference is entirely about the day it becomes due. Money that grinds down is being repaid out of the ordinary run of trading. Money that arrives in one lump has to be met on one date out of whatever cash the company has, whatever it can raise, or whatever a lender is willing to replace it with on that day. A household feels this the same way: the same amount repaid monthly is a habit, and the same amount due at once is an event.

Step 5. Who has a claim over what?

Go back through the three tranches and write down, for each one, whether a lender holds a claim over named assets and where that lender stands in the queue. Read it off the disclosure and add nothing. Security sorts one total into two very different positions without changing the total by a single rupee.

Tranche 1 is secured. Tranche 3 is secured too, against receivables and inventory. Those two assets turn over fastest, and that makes them both the most useful and the most volatile things to be secured against. Tranches 1 and 3 together are Rs 4,00,00,00,000 of the Rs 6,00,00,00,000 with a claim over named assets. Tranche 2, the Rs 2,00,00,00,000 of debentures, is unsecured. The debenture holder is lending against the business as a going concernA business that is taken to carry on trading, so what it holds counts for what it can keep earning rather than what a hurried sale would fetch. rather than against a pledge over anything in particular.

And here is the part that matters more than any of it: this disclosure states no ranking as between tranche 1 and tranche 3. Both are secured, and nothing states which of them stands ahead of the other if there is not enough to satisfy both. The silence is not resolved by assuming. The missing ranking is written down as a thing the disclosure does not say, and it goes into step 9.

Step 6. Where are the covenants, and what if there are none?

A covenant is a promise inside a loan agreement that the borrower will keep some measure inside an agreed limit. The promise is the mechanism by which a lender gets a say before things go wrong rather than after. So they are looked for, on each of the three tranches, one at a time.

On this record nothing is found. Not a level, not a test, not a ratio. The correct output of a step that returns nothing is a written absence and a list of the places looked in, and it is not a sentence about what the covenants probably say.

Where would a reader look? The loan agreement itself for tranche 1. A debenture issue runs on one master document rather than on a separate contract with each holder, so tranche 2 is read in the debenture trust deedThe master agreement behind a debenture issue, held by a trustee who acts for all the holders at once instead of each of them separately.. A registered chargeA note filed with the companies registrar recording that a named lender has taken a claim over particular assets of the borrower. filed against the company's assets with the Ministry of Corporate Affairs at mca.gov.in. And the company's own disclosures to the Securities and Exchange Board of India at sebi.gov.in. Four places, named, and a line saying that none of them was available for this reading.

Step 7. What day of the year is being looked at?

The season the balance sheet date falls in for this particular business is the first question, and it comes before any figure that can move within the year is quoted. A term loan cannot move much: it is drawn once and repaid on a schedule. A facility secured on receivables and inventory is drawn as stock builds and repaid as customers pay, so it moves constantly. A year-end drawn balance is a photograph of one day, and a facility of this kind is a film.

Every reader has seen this at street level. A vegetable seller borrows more in the week before a festival, when the cart is loaded and nothing has been sold yet, and repays most of it in the week after. The balance outstanding on any single day is a true answer that describes only that day. Sankalp Industrial Systems Limited runs the same cycle at a different size, driven by its own operating cycleThe stretch between paying for stock and collecting the cash a customer eventually pays for it..

The disclosure gives one figure for tranche 3, Rs 1,00,00,00,000 drawn at Year 0, and no figure whatever for any other day. So the peak drawing is unknown. Not high, not low, not roughly the same. Unknown, and a reading says so in exactly those words rather than treating the one figure it has as a maximum.

Step 8. Which ratios, and on which base?

Four different questions are being asked, so only now is the structure put back together, and it is put back four times. Four ratios come out of one structure on one day, and each one answers something the other three do not.

Gross debt against earnings before interest, tax, depreciation and amortisation (EBITDA). Rs 6,00,00,00,000 over EBITDA of Rs 2,88,00,00,000 is 2.08 times. Net debt against EBITDA. Take the Rs 1,20,00,00,000 of cash off first, giving net debt of Rs 4,80,00,00,000, and 4,80 over 2,88 is 1.67 times. Interest cover. Interest of Rs 48,00,00,000 against earnings before interest and tax (EBIT) of Rs 2,40,00,00,000 is exactly 5.00 times. And the mix at market: gross debt of Rs 6,00,00,00,000 over total capital of Rs 24,00,00,00,000, being the Rs 18,00,00,00,000 market capitalisation plus the debt, is exactly 25.0 per cent.

Notice how much work the phrase on which base is doing. The first two ratios differ only in whether cash was netted off, and gross always sits above net wherever the company holds any cash at all. The fourth uses market capitalisation rather than the book value of equity, and swapping those two bases moves the answer a long way. So a reading quotes both leverage figures in the same sentence and names the base beside each one. Anything else invites the reader to assume the base that flatters.

Step 9. What could not be found?

Go back through the eight steps and write down, as a list, every place where the record returned nothing. Do not fill any of them in. The reader of an analysis that looks complete has no way of knowing which of its sentences to check. An analysis that names what it could not find is the more useful of the two.

Seven things are missing from this reading. There are no covenant levels on any tranche. There are no drawn balances inside the year for tranche 3, so there is no peak. There is no figure for undrawn headroom on that facility. There is no ranking as between the two secured tranches. There is no statement of which entity in the group did the borrowing. Sankalp Coatings Private Limited, invented, is only 75.0 per cent held, so the borrowing entity matters here. There is no lease obligationWhat a company has committed to pay for the use of an asset it hires rather than buys. disclosed. And there is no guaranteeAn undertaking by one party to step in and pay if another party does not. given to anybody outside the group.

Then there is the largest gap of all, and it is not on that list because it is of a different kind. The disclosure puts Rs 3,00,00,00,000 on the closing date of Year 5 and then goes silent about what happened next. The outcome was not recorded. So the reading states the instalment, states that no outcome is recorded, and stops there. Most such instalments are refinanced, so the temptation to write that this one was is strong. The strength of that temptation is exactly the reason to name the rule rather than to trust judgement in the moment.

What does a finished reading actually look like?

A finished reading looks like a description with its gaps named, and it fits in a paragraph. Three tranches totalling Rs 6,00,00,00,000, reconciling exactly to the disclosed figure. A blended rate of 8.00 per cent, weighted by amount drawn. A repayment line that is flat for four years and then steps, with Rs 3,00,00,00,000 payable as a lump on the closing date of Year 5 and Rs 2,00,00,00,000 two years after that. Rs 4,00,00,00,000 secured, with no ranking disclosed between the two secured tranches. Gross leverage 2.08 times and net leverage 1.67 times against EBITDA of Rs 2,88,00,00,000. Interest cover of exactly 5.00 times. A debt share of exactly 25.0 per cent at market weights. And seven named gaps.

Every sentence in that paragraph can be checked against the disclosure by somebody who has never met its author, and that is the only property of a reading that actually matters. The word safe cannot be checked against anything. Neither can aggressive, conservative or appropriate. Safe, aggressive and conservative are also the first words a reader will quote back. A word that can be checked against nothing is the worst possible place to carry an opinion. The structure gets described, what could not be found gets named, and the reader does the judging.