Monday, October 1, 2012

Business Risk and Acquisition Finance

There are two main types of risk that companies face: Business Risk and Financial Risk.  A basic tenet of acquisition finance is that companies with less business risk can afford to take more financial risk and vice versa.

Business risk deals with the inherent volatility of measures like sales, revenue,  EBIT or EBITDA.  For example,  Humphrey's (a popular restaurant chain in the Netherlands) has different business risk than say, TransCanada Corporation (a natural gas utility in Canada).  Business risks will be different because of country factors, size, governance and a host of other items.  But business risks are different right from the top of the income statement.  A restaurant chain is more likely to have greater swings in revenue (and the EBIT or EBITDA linked to that revenue) than the utility.  Because of this, the utility can afford more financial risk and is likely to be more highly levered.

How much debt is too much?  That is too complicated an issue to cover in a short blog, but earnings coverage ratios, tied to industry norms, are often used as a guide.  The larger swings in EBIT for the more volatile company mean less ability to safely 'cover' a given amount of interest.  Hence, the lower amount of debt.

Incidentally, as individuals, we face the same logic: you and I could have the same average yearly salary but if mine is based on commissions while yours is fixed, I will be unable to borrow as much as you.

Obviously, there is a lot more to structuring the deal than this, but matching the volatility of the assets to the mix of debt and equity is a fundamental principle.  Incidentally, this matching of asset volatility often extends (or should extend) to the way executive compensation is structured, but that's a subject for some other time.


All the best,

Ralph

2 comments:

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