Fınancıal Statement Analysıs (ENG) — Ünite 7 Soru-Cevap

The capital structure of a company is defined as the composition of the long term financings.

The company has two basic long term sources:

• External funding in the form of long term borrowing
• Shareholders’ equity

The main differences between long term borrowings and Shareholders’ equity 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 company specific factors affecting the capital structure of a company:

• The Asset Structure of the Company
• Profitability
• The Size of the Company

• The Company Risk

• Tax

• Tax Shields Other Than Debt

• The Growth Opportunities

• The Liquidity Level of the Company

• The Cost of Borrowing

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. Referring to the Agency Cost Theory, the companies that have higher leverage ratios generally make investments under optimal level and this causes wealth transfer from the lenders to the shareholders. The lenders require additional security in order to ease the effects of such problematic transfers. Whenever the company fails to provide additional security, it either borrows under a high interest rate or issues new stock. Furthermore, the liquidation value of a company increases as the proportion of tangible fixed assets increases. All these indicate that there exists a relation between the proportion of tangible fixed assets and the level of leverage.

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:

• 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 leverage level of 4 means that 1% change in the Earnings Before Interest and Taxes (EBIT) of the company causes an increase in Earning per Share (EPS) by 4%.

When evaluating the long term debt paying ability of a firm, only the ordinary income items should be taken into account.

The extraordinary income and expenses occurred one time together with the effects of the changes in accounting applications should be removed from the analysis.

Debt 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.

It is clear that the company finances nearly 36% of its assets by the liabilities.

1. Reserves for Debt and Expense
2. Deferred Taxes

Net Tangible Fixed Assets

Deferred Taxes: The deferred tax is calculated on the basis of the difference between the recorded value of an asset or liability and the tax value. The deferred tax may be in the forms of deferred tax asset or deferred tax liability.

Deferred tax asset is the amount that can be recovered in the future periods by the use of deductible contemporary amounts, past year losses and unutilized tax exemptions.

Deferred tax liability is the amount to be paid in the coming periods stemming from contemporary differences.

If Tangible Assets to Long Term Debt Ratio result is lower than 1, it means that all of the tangible assets are financed by the long term debt and no short term funding or equity is used. 

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:

In case of bankruptcy or liquidation when the fixed assets are to be disposed, the type of the fixed assets gains importance. The fixed assets provide a buffer for the losses. In this framework, the fixed assets should
be assessed when evaluating the long term debt paying ability of a company.

The financial leasing transactions are generally long term in nature and they are reflected in the balance sheet of the lessee. The operational leases are not recorded in the balance sheet and they are explained in
the footnotes and the relevant periodic payments are booked as rent expense