Evaluating Financial Management: Analyzing Financial Leverage

Evaluating Financial Management: Analyzing Financial Leverage

1. Financial leverage enables a firm to have an asset base larger than its equity

2. The firm can agument its equity through

   • borrowing
   • the creation of other liabilities such as acc payable, accrued liabilities, and deferred taxes

3. Financial leverage increases a firm's ROE as long as the cost of the liabilities is less than the return from investment these funds

4. Distinguish

   • interest-bearing liabilities
     • explicit
       • note payable
       • other forms of short-term and long-term debt
     • implicit
       • capital lease obligations
       • pension obligations
   • no interst- bearing liabilities
     • accts payable
     • deferred taxes

5. Ratios

   • Current liabilities and short-term liquidity
     • The following ratios are useful in evaluating the risk related to a firm's current liabilities
       • 1. Current ratio
       • 2. Quick ratio
       • 3. Cash ratio
       • 4. Operating cash flow ratio
     • All ratios attempt to measure the firm's ability to repay its current liabilities
       • The first three
         • compare a firm's current liabilities with its short-term assets that can be used to repay those liabilities
       • The fourth
         • focuses on the ability of the firm's operations to generate the resources needed to repay its current liabilities
     • it can be noted that the operating lease adjustment had no impact on these ratios
   • Debt and Long-term Solvency
     • A company's fincial leverage is also influenced by its debt finanacing policy
     • Benefits from debt financing
       • First, debt is typically cheaper than equity because the firm promises predefined payment terms to debt holders
       • Second, in most countries interest on debt financing is tax deductible whereas dividends to shareholders are not tax deductible
       • Third, debt financing can impose discipline on the firm's management and motivate it to reduce wastful expenditures
       • Fourth, for non-public debt, it is likely to be easier for management to communicate their proprietary information on the firm's strategies and prospects to private lenders than to public capital markets
     • The optimal capital struture for a firm is determined primarily by its business risk.
       • low business risks
         • cash flows are highly predictable when there is little competition or there is little threat of technological changes
         • can rely heavily on debt financing
       • high business risk
         • more competition and more threat of technological changes
         • a firm's operating cash flows are highly volatile
         • its capital expenditure needs are unpredictable
         • it may have to rely primarily on equity financing.
     • Ratios
       • 1. Liabilities to equity ratio
         • reformulates one of the three primary ratios underlying ROE, the assets-to-equity ratio (it is the assets-to-equity ratio minus one)
       • 2. Debt-to-equity ratio
         • an indication of how many dollars of debt financing the firm is using for each dollar invested by its shareholders
       • 3. Net-debt-to-equity ratio
         • uses net debt, which is total debt minus cash and marketable securities, as the measure of a firm's borowings
       • 4. Debt-to-capital ratio
         • measures debt as a proportion of total capital
       • 5. Net-debt-to-net-capital ratio
         • measures debt as a proportion of total capital
       • The ease with which a firm can meet its interest payments is an indication of the degree of risk associated with its debt policy
         • Interest coverage (earnings basis)
           • the dollars of earnings available for each dollar of required interest payment
         • Interest coverage (cash flow basis)
           • the dollar of cash generated by operations for each dollar of required interest payment
         • A coverage ratio of one implies that the firm is barely covering its interest expense through its operating activities, which is a very risky situation
         • The larger the coverage ratio, the greater the cushion the firm has to meet interest obligations

6. Key Analysis Questions

   • Some of the business questions to ask when the analyst is examining a firm's debt policies follow:
     • Does the company have enough debt? Is it exploiting the potential benefits of debt - interest tax shields, management discipline and easier communication?
     • Does the company have too much debt given its business risk? What type of debt covenant restrictions does the firm face? Is it bearing the costs of too much debt, risking potential financial distress and reduced business flexibility?
     • What is the company doing with the borrowed funds? Investing in working capital? Are these investments profitable?
     • Is the company borrowing money to pay dividends? If so, what is the justification?