ISL459U-FINANCIAL STATEMENT ANALYSIS
Chapter 7: Long Term Debt Paying Ability Analysis
Capital Structure
The capital structure of a company is defined as the composition of the long term financings. Each company strives to find the optimal capital structure which maximizes the market value at minimum capital cost. The capital, hereby, is defined as the long term external funding and shareholder’s equity. In the accounting sense; capital means only the amounts provided by the partners of a company.
The company has two basic long term sources:
• External funding in the form of long term borrowing • Shareholders’ equity
The main differences between these sources are:
• While the borrowings should be repaid in the given period, the capital is not required to be repaid. • There exist different rights of two sources against the profit of the company. The lenders have priority against the shareholders. The repayments to the lenders should be made irrespective of the profitability of the company so the lenders can take legal action. The shareholders do not receive even dividends if they decide to retain the profit. • In liquidation, firstly the lenders receive their payments, then the shareholders can get the remaining, if exists. • While the lenders do not have voting rights in the management, the shareholders manage the company. • The companies should be careful to utilize the external funding in the level that they can meet the relevant payment obligations.
The Approaches About the Capital Structure
The theory proposed by Modigliani-Miller (MM) forms the basis of the capital structure. MM assumes that the markets are efficient and in an environment where there exist no taxes the investment and financing decisions are irrelevant. The capital structure is independent from the cost of capital and the market value.
Factors Affecting Capital Structure
The factors affecting the capital structure of a company can be categorized under three groups; company specific factors, factors specific to the financial markets and macroeconomic factors.
The company specific factors are:
• The Asset Structure of the Company: It is accepted that the proportion of the tangible fixed asset to total assets affects the capital structure of a company • Profitability: Under Tradeoff Theory, the optimal capital structure of a company is generated by
balancing the tax advantage of the borrowing and costs attached to the external financing. • The Size of the Company: The Balancing Theory proposes that there exists a positive relation between the size of the company and the leverage level as big companies have lower probability of bankruptcy and lower relative cost of bankruptcy. • The Company Risk: The risky companies which have higher default risk should not utilize further leverage. • Tax: The most important advantage of external borrowing is the deduction of the interest expense from the corporate tax base which is named as a tax shield. It is empirically stated by many studies that there exists a positive relation between the tax base and the level of leverage. • Tax Shields Other Than Debt: The tax shields other than debt are depreciation, retirement funds, investment credits and investment deductions. The companies which have such kinds of tax shields have less incentive for additional borrowing. • The Growth Opportunities: Referring to Tradeoff Theory, the companies which have the capacity to grow by using intangible fixed assets have less incentive to borrow as compared to companies which have tangible fixed assets. Referring to the Agency Theory, the agencies costs attached to the borrowing are generally higher for the companies which have more flexible growth potential. • The Liquidity Level of the Company: Referring to the Pegging Theory, the more a company is liquid, the less it uses external borrowing. Agency Theory proposes that the managers may increase the agency costs attached to the borrowings by manipulating the liquid assets in favor of the shareholders. In this regard, it is expected that there exists a negative relation between the level of liquidity and borrowing in a company. • The Cost of Borrowing: The lower cost of borrowing makes it more attractive and the debt to equity of a company increases. It is proposed that there exists a positive relation between cost of borrowing and the level of leverage.
The Factor Impairing the Optimal Capital Structure
The optimal capital structure contributes to maximization goal of the value of the company. The optimal capital structure can be impaired depending on the changing conditions in the capital markets, the developments in the economy and the attitudes of the shareholders and managers. These factors are summarized below:
• Control: In the corporations, each share gives to its holder one voting right. Consequently, issuance of new shares may cause reduction in the
controlling power of the existing shareholders. Taking this into consideration, the existing shareholders do not prefer new stock sales and this may cause the level of leverage increases. • The Planning of Borrowing Activities: Sometimes the financial managers postpone the borrowing decisions because of the turmoil in the business conditions. This enables the company to increase the leverage in the tough times. • Financial Leverage and Financial Risk: The level of financial leverage determines the degree of interaction between the profit before interest and taxed and earning per share. It imposes period interest payment obligations for the company. The higher the amount of borrowed funds is, the higher the financial leverage of the company is.
The financial leverage level of a company is calculated by the following formula:
Financial Leverage Level = Change in Earning per Share(%) divided by Change in Profit Before Interest and Taxes (%)
The Determination of Long Term Debt Paying Ability-Income Statement Approach
In the long-run, there exists a relation between the profit reported in the income statement and the ability to pay long term debt. The following ratios are used to determine the paying ability:
• The Interest Coverage Ratio • The Coverage Ratio for Fixed Financing Expenses
The Interest Coverage Ratio
The interest coverage ratio determines the long term debt paying ability in the means of the income statement. The higher the interest coverage ratio is, the lower the risk of default for the interest payments becomes. When the default risk of a company is low, it has more ability to roll over the existing principal payments. This ratio also tells how much decrease in the income is tolerable in order not to cause any difficulty to meet its interest payment obligations. However, the companies should also consider the ability to meet the principal payments as well. A stable interest coverage ratio is preferred and whenever a company has a stable ratio by time, it has more ability to use longer term external financing.
Interest Coverage Ratio = Earning Before Interest and Taxes divided by Earning Interest Expense
Other items that should be removed when making analysis are:
• Interest Expense: When calculating the interest coverage ratio, the interest expense should be added to the net income. Otherwise, the ratio will be underestimated. By using the Earnings Before Interest and Taxes item in calculation, this problem can easily be addressed.
• Corporate Tax: As the interest expenses are tax deductible, they are also not considered in calculation.
The Coverage Ratio for Fixed Financing Expenses
The coverage ratio for fixed financing expenses is another ratio used for evaluating the long term paying ability of a company under the income statement approach. This is a modified version of the interest coverage ratio. Although there is no consensus about which items will be included in the calculation, a portion of the long term operational lease payment is added to the interest expense. The leasing operations are realized in the following two ways:
Financial (Capital) Leasing: This is a long term leasing whereby the ownership of the machinery and equipment is kept by the lessor but the control of them belongs to the lessee. In the term of the contract, the ownership passes to the lessee.
Operational Leasing: The term of the lease contract is shorter than the economic life of the leased machinery and equipment. The contract is cancelable by giving prior notification as set in the contract.
The coverage ratio for fixed financing expenses is calculated by the following formula:
Coverage Ratio Ratio for Fixed Financing Expenses= Operational Profit+ Interest Expense Share in Lease Payments Divided by Interest Expense+ Interest Expense Share in Lease Payments
The Determination of Long Term Debt Paying Ability-Balance Sheet Approach
The balance sheet approach for the evaluation of the long term debt paying ability of a company is also realized by using some ratios based on the balance sheet items. These are:
• • Debt Ratio (Leverage Ratio) • • Debt to Equity Ratio • • Debt to Net Tangible Assets Ratio • • Tangible Assets to Long Term Debt Ratio • • Fixed Assets to Permanent Capital Ratio
Debt Ratio (Leverage Ratio)
This ratio compares total assets of the company with total liabilities and generally named as leverage ratio. This ratio indicated the proportion of assets that are financed by the external funding sources. In the framework of debt paying ability, lower leverage ratio is preferred. The leverage ratio is calculated by using the following formula:
Leverage Ratio = Total Liabilities divided by Total Assets
Debt to Equity Ratio
Debt to equity ratio compares debt with the equity of the company. It indicates the level of protection for the lenders in case of bankruptcy. In the framework of the long term debt paying ability, a low debt to equity ratio is
preferable. The ratio is calculated by the following importance. The fixed assets provide a buffer for the formula: losses. In this framework, the fixed assets should be assessed when evaluating the long term debt paying ability Debt to Equity = Total Liabilities divided by Total Equity of a company. Debt to Net Tangible Assets Ratio The financial statements cannot fully reflect the quality of The debt to net tangible asset ratio is used to elaborate the the fixed assets and generally they do not show the real long term debt paying ability of a company. It shows the values or market values. The book values of the assets level of protection provided to the creditors in the time of may vary with market values. Such a misstatement can bankruptcy. As for all debt ratios, the lower debt to net cause lack of sufficient funds to be paid to the creditor. tangible asset ratio is preferred. In the calculation the intangible assets such as goodwill, brand recognition, Long term Leasing
patents and trademarks are excluded from total assets as The financial leasing transactions are generally long term they do not create cash inflow. By this nature, it is in nature and they are reflected in the balance sheet of the accepted as a more conservative ratio than the leverage lessee. The operational leases are not recorded in the ratio and debt to equity ratio. The debt to net tangible asset balance sheet and they are explained in the footnotes and ratio is calculated by the following formula: the relevant periodic payments are booked as rent expense. It is accepted that one third of the periodic payments under Debt to Net Tangible Asset Ratio= Net Tangible Fixed the operational leases is interest and the remaining two Assets divided by Total Equity third should be booked under both fixed assets and long Tangible Assets to Long Term Debt Ratio term liabilities.
The ratio of tangible assets to long term debt measures the level of the fixed assets financed by the long term external borrowing. The following formula is used for calculation:
Tangible Asset to Long term Debt Ratio= Net Tangible Fixed Assets divided by Long term Debt
A ratio lower than 1 means that all of the tangible assets are financed by the long term debt and no short term funding or equity is used. A ratio higher than 1 means that a portion of the tangible assets is financed by the external funding. The difference shows the amount of tangible fixed assets financed by short term borrowing. In calculation of the ratio, the net tangible fixed assets should be used, but two issued should be addressed:
• In high inflation environments, the depreciation amount should not be deducted from the tangible assets.
• When a big portion of the fixed assets is amortized and in the case of accelerated depreciation method is used, the gross fixed assets should be used.
Fixed Assets to Permanent Capital Ratio
Permanent capital is defined as the total of long term liabilities and the equity. It measures the strength of the company for financing the fixed assets. The following formula is used for calculation:
Fixed Asset to Permanent Capital Ratio= Net Tangible Fixed Assets divided by Long term Debt+ Equity
Specific Factors Affecting Long Term Paying Ability
The type of fixed assets and long term leasing affect long term paying ability.
Fixed Assets
In case of bankruptcy or liquidation when the fixed assets are to be disposed, the type of the fixed assets gains