Intercompany Balances: Reading Them Entity by Entity

When a parent prepares consolidated accounts, it adds its subsidiaries together line by line and then removes everything they owe one another. The international consolidation standard, adopted in New Zealand and Australia in their own versions, requires intragroup assets, liabilities, income and expenses to be eliminated in full, and FRS 102, which most UK mid-market groups use, says the same. A group cannot owe itself money, so for the group the elimination is right.

For a lender to one company it hides the point. A bank whose borrower is the operating company has a claim on that company's assets, and in that company's accounts the balances are still there. A receivable from a sister company is collectable only if the sister can pay. A loan from the parent is a debt the borrower must repay, and unless the documents subordinate it, the parent can be repaid while the bank waits, or claim alongside unsecured creditors in a liquidation. And a balance that grows every year is often the trace of cash moving out of the borrower to fund another part of the group.

They arise in three ways. Trading: one company sells goods or services to another on account, at a price the group sets, which tax rules expect to be at arm's length when the companies are in different countries. Lending: a parent passes borrowed money down to a subsidiary, or a cash-rich subsidiary lends up. Cash pooling: a zero-balancing arrangement sweeps accounts to a header account each night and creates a loan between the companies for every dollar moved.

Finding them depends on the market and the accounts. A UK company's balance sheet shows amounts owed by and to group undertakings in aggregate, because the statutory formats require it, but FRS 102 does not require the related-party note to describe transactions between wholly owned members of a group. In New Zealand, many mid-sized companies prepare only special purpose accounts to Inland Revenue's minimum requirements, and in Australia a small proprietary company is generally not required to prepare a financial report unless directed to. Whatever the accounts show, a lender asks for the intercompany ledger: each balance by counterparty, its movement over the year, and any agreement behind it.

A family group, constructed for this page like every figure in it, owns a tile manufacturer and a sister company running twelve tile showrooms. The bank lends to the manufacturer. The manufacturer sells to the showrooms on account, and the showrooms, which lost money this year, have been slow to pay. The manufacturer's balance sheet, in US$m:

Two numbers change the file. The receivable from the showrooms grew by US$4.5m in a year, so US$4.5m of the manufacturer's sales did not arrive as cash: it has been funding its sister's losses through its trade terms, and its own operating cash flow is that much weaker than its profit. Set the receivable aside, as a lender would until the showrooms show they can pay, and the equity beneath the bank's loan falls from US$10.0m to US$3.5m. If the family's US$3.0m loan is postponed behind the bank, the lender can count it as a further layer of loss-absorbing money, and the reading recovers to US$6.5m.

In the group's consolidated accounts both balances disappear, the showrooms' losses are absorbed into one set of figures, and the group may look adequately capitalised. Unless the showrooms company guarantees the loan, the bank has no claim on its assets, whatever the group's figures show.

A guarantee structure changes the reading. If every company in the group guarantees the bank's debt, the bank has a claim on the showrooms company too, and the consolidated figures become relevant to it: the showrooms' debt to the manufacturer is then a claim between two companies that both owe the bank. Without that, the balance is an unsecured claim on a loss-making company the bank cannot reach. The cross-guarantee and the intercompany ledger are read together for that reason.

Insolvency law adds a layer in two of the three markets. In New Zealand a court can, in limited circumstances, order a related company to contribute to another's liquidation, or order that the liquidations of related companies proceed together as if they were one company. In Australia a court can make a pooling order, and a liquidator can make a pooling determination if the creditors approve it; a pooling order extinguishes the debts between the pooled companies. A lender does not plan on that outcome, but it explains why a balance that looks like an asset in one company's accounts can be worth very little when the group fails together.

DEFINED IN ONE PARAGRAPH → · ZERO-BALANCING → · RELATED-PARTY TRANSACTIONS →

In the credit paper, intercompany balances move three numbers. Tangible net worth, which a lender often restates without amounts due from related companies. Operating cash flow, which a growing receivable from a sister company reduces. And the borrowing base, where an invoice finance or asset-based lender commonly excludes debts owed by related companies from the eligible ledger.

In the documents, the lender asks for the flows to be controlled. Debts the borrower owes other group companies can be subordinated or postponed, so the parent is not repaid ahead of the bank. Lending by the borrower to other group companies can be limited, or allowed only to companies that guarantee the loan. And the periodic reporting can include the intercompany ledger, so the next US$4.5m appears in the quarter it happens rather than in the annual accounts.

THE MONTHLY PACK → · CONNECTED EXPOSURE →