9
Lecture
Capital structure and solvency anlaysis
Basics of Solvency
Capital structure
Motivation for debt
Financial leverage
Capital composition
And Solvency
Common-size statement
Capital structure measures
Interpretation of measures
Asset-based Solvency measures
Introduction to earning coverage
Facts
PROFITABILITY
DEVELOPMENT
LIQUIDITY
SOLVENCY
Facts
Solvency
Solvency––refers
refersto
toaacompany’s
company’slong-run
long-runfinancial
financial
viability
viabilityand
andits
itsability
abilityto
tocover
coverlong-term
long-term
obligations
obligations
Capital
Capitalstructure
structure----financing
financingsources
sources
and
their
attributes
and their attributes
Earning
Earningpower
power—
—recurring
recurringability
abilityto
to
generate
generatecash
cashfrom
fromoperations
operations
Loan
Loancovenants
covenants––protection
protectionagainst
againstinsolvency
insolvencyand
and
financial
distress;
they
define
conditions
of
default
financial distress; they define conditions of defaultat
ataa
level
levelto
toallow
allowthe
theopportunity
opportunityto
tocollect
collecton
onaaloan
loanbefore
before
severe
severedistress
distress
Capital Structure
Equity
Equityfinancing
financing
•• Risk
Riskcapital
capitalof
ofaacompany
company
•• Uncertain
Uncertainand
andunspecified
unspecifiedreturn
return
•• Lack
of
any
repayment
pattern
Lack of any repayment pattern
•• Contributes
Contributesto
toaacompany’s
company’sstability
stabilityand
andsolvency
solvency
Debt
Debtfinancing
financing
•• Must
Mustbe
berepaid
repaidwith
withinterest
interest
•• Specified
repayment
Specified repaymentpattern
pattern
When
When the
the proportion
proportion of
of debt
debt financing
financing is
is higher,
higher, the
the higher
higher
are
the
resulting
fixed
charges
and
repayment
commitments
are the resulting fixed charges and repayment commitments
Motivation for Debt
From
From aa shareholder’s
shareholder’s perspective,
perspective, debt
debt financing
financing is
is less
less
expensive
expensivethan
thanequity
equityfinancing
financingbecause:
because:
1.Financial
on most
most
1.Financial Leverage--Interest
Leverage--Interest on
debt
is
fixed,
and
provided
interest
debt is fixed, and provided interest is
is
less
than
the
return
earned
from
debt
less than the return earned from debt
financing,
financing, the
the excess
excess return
return goes
goes to
to
equity
equityinvestors
investors
2.Tax
2.TaxDeductibility
Deductibilityof
ofInterest--Interest
Interest--Interestis
is
aatax-deductible
tax-deductibleexpense
expensewhereas
whereas
dividends
dividendsare
arenot
not
Financial Leverage
----use
useof
ofdebt
debtto
toincrease
increasenet
netincome
income
Leverage:
Leverage:
•• Magnifies
Magnifies both
both managerial
managerial success
success (profits)
(profits) and
and failure
failure
(losses)
(losses)
•• Increases
Increasesrisks
risks
•• Limits
flexibility
Limits flexibilityin
inpursuing
pursuingopportunities
opportunities
•• Decreases
Decreasescreditors’
creditors’protection
protectionagainst
againstloss
loss
Companies
Companieswith
withleverage
leverageare
aresaid
saidto
tobe
be
—
when
a
company
is
using
equity
— when a company is using equityfinancing
financingto
toobtain
obtain
debt
debtfinancing
financingin
inaadesire
desireto
toreap
reapreturns
returnsabove
abovethe
thecost
costof
of
debt.
debt.
Financial Leverage - Illustration
Trading on the Equity—Returns for Different Earnings Levels ($ thousands)
Trading on the Equity—Returns for Different Earnings Levels ($ thousands)
Financing Sources
Financing Sources
Income before
Income and
before 10 Percent
Interest
Interest
10 Percent
Assets
Debt
Equity
Taxes and Debt
Interest Taxes*
Assets
Debt
Equity
Taxes
Debt Interest Taxes*
Year 1:
Year 1:
Risky,
Inc. $1,000,000 $400,000
Risky, Inc.
Inc. 1,000,000
$1,000,000 $400,000
Safety,
Safety, Inc. 1,000,000
Year 2:
Year 2:
Risky,
Inc. 1,000,000 400,000
Risky, Inc.
Inc. 1,000,000
1,000,000 400,000
Safety,
Safety, Inc. 1,000,000
Year 3:
Year 3:
Risky,
Inc. 1,000,000 400,000
Risky, Inc.
Inc. 1,000,000
1,000,000 400,000
Safety,
Safety, Inc. 1,000,000
Return on
Return on
Net
Net Income + [Interest
Net
Net
+ [Interest Assets† Equity‡
Income
(1 -Income
Tax Rate)]
Income
(1 - Tax Rate)]
Assets† Equity‡
$600,000
$600,000
1,000,000
1,000,000
$200,000 $40,000
$200,000 $40,000
200,000
200,000
$64,000
$64,000
80,000
80,000
$96,000
$120,000
$96,000
$120,000
120,000
120,000
120,000
120,000
600,000
600,000
1,000,000
1,000,000
100,000
100,000
100,000
100,000
40,000
40,000
24,000
24,000
40,000
40,000
36,000
36,000
60,000
60,000
60,000
60,000
60,000
60,000
6.0
6.0
6.0
6.0
6.0
6.0
6.0
6.0
600,000
600,000
1,000,000
1,000,000
50,000
50,000
50,000
50,000
40,000
40,000
4,000
4,000
20,000
20,000
6,000
6,000
30,000
30,000
30,000
30,000
30,000
30,000
3.0
3.0
3.0
3.0
1.0
1.0
3.0
3.0
* Tax rate is 40 percent.
Tax rate
40 percent.
† *Return
onisassets
= Net income + Interest (1 – 0.40)/Assets.
† Return on assets = Net income + Interest (1 – 0.40)/Assets.
‡ Return on equity = Net income/Shareholders’ equity.
‡ Return on equity = Net income/Shareholders’ equity.
12.0% 16.0%
12.0% 12.0
16.0%
12.0
12.0
12.0
Financial Leverage- Illustrating Tax
Deductibility of Interest
Consider
Considertwo
twocompanies’
companies’results
resultsfor
forYear
Year2:
2:
Year
Year22Financials
Financials
Risky,
Risky,Inc.
Inc.Safety,
Safety,Inc.
Inc.
Income
Incomebefore
beforeinterest
interestand
andtaxes
taxes
Interest
(10%
of
$400,000)
Interest (10% of $400,000)
Income
Incomebefore
beforetaxes
taxes
Taxes
(40%)
Taxes (40%)
Net
Netincome
income
Add
Addback
backinterest
interestpaid
paidto
tobondholder
bondholder
Total
return
to
security
holders
Total return to security holders
(debt
(debtand
andequity)
equity)
$$
$$
$$
$$
100,000
100,000 $$
40,000
40,000
60,000
60,000 $$
24,000
24,000
36,000
36,000 $$
40,000
40,000
100,000
100,000
—
—
100,000
100,000
40,000
40,000
60,000
60,000
—
—
76,000
76,000
60,000
60,000
Financial Leverage
Total assets
Common equity capital
Greater
Greater the
the proportion
proportion of
of financing
financing from
from equity
equity vs.
vs. debt
debt
lower
lowerthe
thefinancial
financialleverage
leverageratio
ratio
Note:
Note:Financial
Financialleverage
leverageratio
ratiois
isaacomponent
component
of
the
disaggregated
return
on
equity:
of the disaggregated return on equity:
ROCE
ROCE==Adjusted
Adjustedprofit
profitmargin
margin Asset
Assetturnover
turnover Leverage
Leverage
Adjustments for Capital Structure - Liabilities
Effect of Converting Operating Leases to Capital Leases on Key Ratios
Financial Ratio
Current Ratio
Total Debt to equity
Long-term debt to equity
Return on common equity
Return on assets
Before
1.08
1.66
0.17
21.7%
8.16%
After
1.01
2.96
1.38
21.4%
5.39%
Common-Size Statements
Capital
Capitalstructure
structurecomposition
compositionanalysis
analysis
•• Performed
Performedby
byconstructing
constructingaacommon
common
-size
statement
of
liabilities
-size statement of liabilitiesand
andequity
equity
••
••
Reveals
Revealsrelative
relativemagnitude
magnitudeof
offinancing
financingsources
sources
Allows
Allowsdirect
directcomparisons
comparisonsacross
acrossdifferent
different
companies
companies
•• Two
TwoVariations—(1)
Variations—(1)Use
Useratios,
ratios,and
and(2)
(2)Exclude
Exclude
current
currentliabilities
liabilities
Capital Structure % of Tangible Invested Capital
39,2
60,0
60,8
78,4
40,0
21,6
-21,4
-26,5
-32,7
-31,2
-43,6
-45,9
-42,3
Mid-size firms
European multinational
companies
Big Italian Groups
-36,8
-19,6
Short-term debts
Long-term debts
Equity
Current Assets
Fixed Assets
Source: Mediobanca, 2002
Capital Structure Measures
Total
TotalDebt
Debtto
toTotal
TotalCapital
Capital(also
(alsocalled
called
))
Capital Structure Measures
!!
Reciprocal
Reciprocal measure
measure of
of this
this ratio—!
ratio—!
Capital Structure Measures
Total Debt to Equity
General merchandise
Educational services
Electrical equipment
Printing and publishing
Motion pictures
Eating and drinking
Food stores
0.0
Source: Dun & Bradstreet
0.2
0.4
0.6
Ratio
0.8
1.0
Capital Structure Measures
""
#
#
!!
!!
$
$
%
%
Capital Structure Measures
Long-Term Debt to Equity Ratio
General merchandise
Educational services
Electrical equipment
Printing and publishing
Motion pictures
Eating and drinking
Food stores
0.0
Source: Dun & Bradstreet
0.1
0.2
0.3
Ratio
0.4
0.5
Capital Structure Measures
""
#
#
important
importantindicator
indicator of
ofenterprise
enterprisereliance
relianceon
onshort-term
short-term
(primarily
(primarilybank)
bank)financing
financing
Interpretation of Capital Structure Measures
Common-size
Common-size and
and ratio
ratio analyses
analyses of
of capital
capital structure
structure mainly
mainly reflect
reflect
risk
capital
structure
capital structure risk
Capital
Capitalstructure
structuremeasures
measuresserve
serveas
asscreening
screeningdevices
devices
Extended
Extendedanalysis
analysisfocuses
focusesfinancial
financialcondition,
condition,results
resultsof
of
operations,
and
future
prospects
operations, and future prospects
Prior
Prior to
to long-term
long-term solvency
solvency analysis,
analysis, we
we perform
perform liquidity
liquidity analysis
analysis
to
be
satisfied
about
near-term
survival
to be satisfied about near-term survival
Additional
Additionalanalyses
analysesinclude
includeexamination
examinationof
of
•• Debt
Debtmaturities
maturities(amount
(amountand
andtiming)
timing)
•• Interest
costs
Interest costs
•• Risk-bearing
Risk-bearingfactors
factors(earnings
(earningspersistence,
persistence,industry
industry
performance,
and
asset
composition)
performance, and asset composition)
Asset-Based Measures of Solvency
Asset
AssetComposition
CompositionAnalysis
Analysis
•• Tool
Toolin
inassessing
assessingthe
therisk
riskexposure
exposureof
ofaacapital
capital structure
structure
•• Typically
Typicallyevaluated
evaluatedusing
usingcommon-size
common-sizestatements
statements
Asset-Based Measures of Solvency
Assets
Assets provide
provide protection
protection to
to creditors--earning
creditors--earning power
power
and
liquidation
value
and liquidation value
Base
Basefor
foradditional
additionalfinancing
financing
Useful
Usefulratios
ratiosinclude:
include:
&& '
'
&&(
(
&&
""
#
#
!
Earnings to Fixed Charges
!
#
)
"
'
#
*
#
!
'
!
Earnings to Fixed Charges
# "*
# "%
# "$
&
# "$
# "
!
#
&
"%
# ")
# "
&
'(
# "%
&
# "$
# "
!
(a)
(b)
(c)
(d)
(e)
(f)
(g)
(h)
Pre-tax income before discontinued operations, extraordinary items, and cumulative effects of accounting changes.
Interest incurred less interest capitalized.
Usually included in interest expense.
Financing leases are capitalized so the interest implicit in these is already included in interest expense. However, the interest portion of long-term
operating leases is included on the assumption many long-term operating leases narrowly miss the capital lease criteria, but have many
characteristics of a financing transaction.
Excludes all items eliminated in consolidation. The dividend amount is increased to pre-tax earnings required to pay for it. Computed as [Preferred
stock dividend requirements]/[1-Income tax rate]. The income tax rate is computed as [Actual income tax provision]/[Income before income taxes,
extraordinary items, and cumulative effect of accounting changes].
Applies to nonutility companies. This amount is not often disclosed.
Minority interest in income of majority-owned subsidiaries having fixed charges can be included in income.
Included whether expensed or capitalized.
For ease of presentation, two items (provisions) are left out of the ratio above:
1.
2.
Losses of majority-owned subsidiaries should be considered in full when computing earnings.
Losses on investments in less than 50-percent-owned subsidiaries accounted for by the equity method should not be included in earnings
unless the company guarantees subsidiaries’ debts.
!
Times Interest Earned
#
Income+Tax expense+Interest expense
Interest expense
!
Interpreting Earnings Coverage
Earnings-coverage measures provide insight into
the ability of a company to meet its fixed charges
High correlation between earnings-coverage
measures and default rate on debt
Earnings variability and persistence is
important
Use earnings before discontinued
operations, extraordinary items, and
cumulative effects of accounting
changes for single year analysis —
but, include them in computing the
average coverage ratio over several years
!
Capital Structure Risk and Return
• A company can increase risks (and potential
returns) of equity holders by increasing leverage
• Substitution of debt for equity yields a riskier
capital structure
• Relation between risk and return
in a capital structure exists
• Only personal analysis can
reflect one’s unique risk and
return expectations
Return
$
Risk
?
+
Altman Z-Score
Z = (12.2X. + (10+2X - + ,1.(2X, + (1+-(X + + (1//0X'
X1 = Working capital/Total assets
X2 = Retained earnings/Total assets
X3 = Earnings before interest and taxes/Total assets
X4 = Shareholders’ equity/Total liabilities
X5 = Sales/Total assets
Z<1.20 implies a high probability of bankruptcy
Z>2.90 implies a low probability of bankruptcy
1.20<Z<2.90 implies an ambiguous area