Targeting a level of balance sheet leverage is a core strategic decision and managing it successfully has a significant impact on the level of shareholder returns. Traditionally, multinational corporates have adopted one of two approaches to managing leverage: Borrow against the fair value of assets where protecting the value of longer-term capital intensive investments is the strategic risk objective. And borrow against future cash flows or earnings (often EBITDA) where the business is asset light in nature and shareholder value is more closely linked to cash flow generation.
Re-translation risk within the first approach is relatively straight forward as the closing exchange rate for the reporting period is used to translate both overseas assets of the foreign subsidiary and debt into the functional currency. If the corporate has correctly aligned the effective currency of its borrowings and delivered on its cash flow plan, the fair (or book) value of its assets relative to debt will be protected.
The second alternative, however, poses a more interesting problem as cash flows or earnings are translated at the average exchange rate for the period, whereas debt is translated at closing rate. Traditionally the effective currency of debt has been aligned in direct proportion to the levels of earnings or cash. But the different exchange rates used to re-translate the two inputs into the leverage ratio can cause this approach to fall down. And the reason is simple: the average exchange rate used for cash flow earnings translation is significantly less volatile within an annual reporting period than the closing exchange rate used to re-translate foreign currency denominated debt.
The corporate will plan for an appropriate level of CAPEX, M&A and dividends in conjunction with its operating cash flow plan and closing leverage target to arrive at a cash flow plan for the period. So how does the corporate minimise the effect of exchange movements upon the reported leverage ratio by adjusting the effective currency of the debt portfolio? The exposure in this situation is the impact arising from the average and closing exchange rates being different from the expected exchange rate when the cash flow plan and the closing leverage target for the year ahead were determined. In the usual financial cycle this would be a spot rate around the time that the annual budget or longer-term business plan is finalised.
A crude real-world model might have exchange rates moving away from the expected rate by an increment of 10% every six months. Debt therefore is exposed to FX impacts of between 80-120% of its expected value over the course of a financial year. EBITDA however, translated at average rates, is only exposed to a range of 90-110%.
So how does the corporate position its currency mix of debt to align to these differing levels of foreign exchange exposure? The answer it to hold less currency debt by proportion to that of the corporate’s earnings. Think of it as matching the weighted outcome between the range in which the exchange rate can move and the value of the currency EBITDA or debt. If the exchange rate used to translate debt can move twice as much as the rate used for EBITDA, then carrying half this proportion of debt compared to EBITDA matches the overall exposure. This produces a lower risk from exchange rate changes to the leverage ratio compared to the traditional approach.
Murari Gattamaneni, a director at HSBC, comments: “When asked to carry out this type of support for a client we start by gaining a thorough understanding of the strategic risk objective. Then after conducting extensive analysis, we were able to confirm the conclusions that the client’s Treasury team had arrived at. This is cutting edge analysis and very topical in the current environment as many clients are looking in detail at policy in this and other areas with the objective of driving further value and de-risk their balance sheets.”
Clearly across the infinite range of exchange rate scenarios that can play out over the course of a reporting period alternative debt portfolios will under or over perform versus others. However, this approach allows the corporate to carry out a meaningful analysis of exchange rate risk to its balance sheet leverage. The corporate can now consider this alongside other factors such as the interest cost resulting from different mixes of currency within its debt portfolio.
Understanding the risk and the tools available to manage it allows management to make informed decisions, which over time should produce a more stable and targeted reported leverage ratio and benefit the creation of shareholder value.
Ben Walters FCT, ACA is a practising corporate treasurer