Capital structure is to an enterprise what a transmission system is to a manual car. Driving in the right gear (balancing debt and equity) allows the car to accelerate smoothly without straining the engine. Too low a gear (excess equity) and the engine revs without speed – growth is sluggish and capital is underutilised. Too high a gear (excess debt) and the engine risks stalling – financial distress looms and flexibility is undermined.
Enter the treasurer, ready to shift into the right gear – one that aligns with the organisation’s strategic investment objectives, risk appetite, industry dynamics and operational context.
Investment priorities drive capital allocation and, by extension, shape the debt narrative. Understanding the financial baseline and business context is key. This includes analysing financial performance and grasping strategic intent, portfolio composition and key differentiators that underpin competitive strength.
Stakeholders, whether leadership or creditors, can hold different views on the inherent business and financial risks. Bridging these perceptions involves weighing the merits and trade-offs of debt across:
Other key considerations include creditor relationships and market timing. Building a borrowing track record improves the chances of future balance sheet support; while minding how attractive a lending arrangement is to a banking partner helps gauge their willingness to support. Financing windows can also open or close based on market conditions and the borrower’s financial strength.
The timing of debt is critical as a debt issuance can falter under unfavourable conditions, underscoring the need for a forward-looking view
A debt policy acts as the organisation’s dashboard for capital structure management, setting speed limits to monitor performance and signalling when to shift gears. It institutionalises governance and aligns financing decisions with business context, risk appetite and cash flows. Financial flexibility, security, and shareholder value can accordingly be balanced.
Financial sustainability hinges on effective credit risk management, which extends to managing financial and business risks as well as macroeconomic dynamics. Collectively, these shape the predictability of cash flows and, in turn, debt affordability. Ascertaining a company’s credit rating helps synthesise the interplay of these factors and is an effective way of translating the Board’s risk appetite and tolerance into credit limits. By modelling credit parameters into the future under predefined cash scenarios, organisations can assess headroom against approved risk thresholds to prevent overleverage and preserve agility as they react to market challenges and opportunities.
The timing of debt is critical as a debt issuance can falter under unfavourable conditions, underscoring the need for a forward-looking view. Once vulnerabilities are identified, scenario analysis can progress to scenario planning. The optimal mix of debt and equity can then be calibrated to balance credit worthiness with minimising cost of capital under evolving market conditions.
Since debt is considered cheaper than equity, the optimal capital structure is one that ramps up debt to a level that minimises WACC while containing default risk within board-approved risk tolerance. Because a credit rating accounts for business risk, financial risk, capital structure and available sources of liquidity, it is considered a pithy indicator of default risk. As such, it can serve as a risk tolerance barometer.
As debt rises, so will cost of equity because shareholders will bear greater earnings risk. Similarly, the cost of debt increases as gearing rises, reflecting a higher chance of financial distress. These increases in cost of capital, however, are counterbalanced by the changing weights of debt and equity. Factoring the above dynamics, a matrix can be developed to sensitise WACC, at various gearing levels, to triangulate the lowest value at the company’s target credit rating.
Having the flexibility to simulate different scenarios steers capital allocation decisions, tests debt serviceability, and helps determine adequate liquidity buffers
Quantifying funding needs and liquidity planning must be underpinned by a dynamic financial model that can integrate business plans with financial strategy. This requires cross-functional collaboration. Treasury owns the funding strategy, but FP&A plays a critical role in sourcing and consolidating inputs from across the business. Ultimate ownership resides with the CFO, ensuring alignment with strategic priorities and board expectations.
The model should provide a forward-looking view of cash flows to help treasury answer key questions:
Without such a model, decisions on borrowing, refinancing or capital allocation risk being reactive, potentially leading to suboptimal cost of capital, liquidity shortfalls and even covenant breaches.
The model should project operating cash flows, investment outlays and financing flows in order to identify liquidity gaps or surpluses over the planning horizon. Cash-generating and cash-consuming assets should be distinguished, as understanding the concentration and distribution of cash sources and uses provides valuable insights into liquidity risk and, by extension, the required buffers and funding needs.
Once a view on future cash flows is formed, the model can integrate debt dynamics:
It is also useful to distinguish accessible cash from restricted or trapped cash, such as funds in escrow or jurisdictions with repatriation constraints.
Financial projections can then be flexed across multiple cash flow scenarios to define a sustainable debt profile. Key strategic levers can include project activation or deferral, the timing and severity of potential downturns, and the pace of recovery. Scenario outputs will reveal vulnerabilities – such as when and to what extent liquidity and covenant pressures emerge – as well as opportunities for strategic refinancing or early debt repayment. Having the flexibility to simulate different scenarios steers capital allocation decisions, tests debt serviceability, and helps determine adequate liquidity buffers.
By quantifying debt capacity, the model can then inform the optimal mix of debt and equity, ensuring that leverage decisions are feasible. Times of heightened uncertainty make the model a strategic necessity as opposed to a ‘nice-to-have’ tool. For treasury, it is the bridge between operational reality and financial foresight, enabling prudent navigation of volatility.
Based on simulated cash scenarios, guardrails can be put in place to manage credit risk according to the organisation’s target credit rating, credit risk being mainly a function of leverage, solvency, and liquidity.
Leverage, or gearing, should tilt debt levels in a way that balances sources of financing (debt to equity) and the debt burden against operating earnings (debt to EBITDA).
Solvency relates to the serviceability of debt obligations. Accordingly, both interest and debt service cover limits should be established (EBIT/interest expense, EBITDA / total debt service).
A liquidity buffer (cash and cash equivalents plus the unutilised portion of committed facilities) can be set to measure coverage of future OPEX and CAPEX requirements. This effectively measures the business’ cash runway, ensuring sufficient liquidity access and reducing refinancing risk. Debt maturity limits can also be set to stagger repayments and mitigate liquidity strain in any given year.
Target levels for the above ratios should be guided by industry practice, credit rating agency guidelines and debt covenants. The above framework would help protect credit standing and ascertain debt affordability.
Debt structuring is ultimately far from being a one-size-fits-all exercise
Debt instruments carry distinct attributes. Beyond pricing, corporates must weigh trade-offs such as flexibility of drawdown and repayment schedules, refinancing risk and transaction closing timelines. Additionally, where the debt sits in a group has an important bearing on the borrower’s credit position. Debt residing at a material subsidiary, a newly established treasury entity or a holding company has different implications on creditors’ claims on cash flows and security requirements.
A centralised approach to debt offers several advantages, including cost efficiency, reduced administrative burden and improved governance. Leveraging group credit strength generally results in lower borrowing costs and less restrictive covenants due to economies of scale and diversification. Furthermore, debt consolidation helps with standardisation of terms, involves fewer internal approval layers and facilitates compliance monitoring and oversight of funding management, particularly when a cash pooling structure and centralised treasury function are in place.
For groups opting for centralised debt, a common question arises: should borrowing occur at the holding company level or a treasury entity that requires a parent guarantee? While overall liability exposure is the same, positioning the treasury entity as the borrower can increase the chances of some rather than all covenants applying to the parent guarantor.
Tax efficiency is also an important consideration when the treasury entity operates in a different tax jurisdiction from the holding company, as variations in tax regimes can create opportunities for optimising overall group tax exposure. This flexibility stems from the discretionary leeway afforded by transfer pricing rules. The potential tax benefit increases when a larger share of intercompany loan interest income is allocated to the treasury entity, and guarantee fees paid by the treasury entity to the holding company are minimised, provided thin capitalisation requirements are met and the ultimate borrowing entity has sufficient tax capacity to take advantage of interest expense deductibility.
In contrast to the above, debt decentralisation may be preferable when operating companies have sufficient profitability and cash-generation capabilities to secure favourable terms independently from parent support. This allows them to benefit from tax-deductible interest while ring-fencing risk by limiting lender recourse to the group’s asset pool. Partial ownership in joint ventures, anticipated carve-outs, and other constraints, such as exchange controls and withholding tax on cross-border intercompany loans, also tip the scales in favour of decentralised debt.
Debt structuring is ultimately far from being a one-size-fits-all exercise. Thoughtful deliberation is required on key factors – such as debt instrument attributes and degree of funding centralisation – to balance cost, flexibility, risk, governance, and compliance burden.
In conclusion, capital structure optimisation is a dynamic exercise that adjusts to the ever-evolving nature of markets and businesses, requiring periodic recalibration and sometimes immediate intervention when material changes in cash flows occur. Putting an organisation’s capital structure in the right gear is about more than ratios: it is about foresight, discipline and adaptability. Done well, it transforms debt from a risk into a strategic enabler, fuelling growth while keeping the enterprise’s engine running smoothly.
Sleiman El Homsi AMCT is head of treasury at Shamal in Dubai