UNIVERSITY OF NAIROBIMSC-FINANCE

DAC 511: CORPORATE FINANCIAL REPORTING AND ANALYSIS

TOPIC 11: CAPITAL STRUCTURE & SOLVENCY ANALYSIS

Presented By: Group 9 Members

CONTENT

1. BASICS OF SOLVENCY

2. CAPITAL STRUCTURE COMPOSITION & SOLVENCY

3. EARNINGS COVERAGE

4. BOND CREDIT RATINGS

5. FINANCIAL DISTRESS

1. BASICS OF SOLVENCY

KEY TERMINOLOGIES SOLVENCY:

This a measure of the firm's ability to pay all debt, particularly long-term debt and is a measure of the firm's long-term survival.

LIQUIDITY:

This is a measure of the firm's ability to pay short-term debt.

CAPITAL STRUCTURE:

The composition of long-term liabilities, specific short-term liabilities, common

equity, and preferred equity which makes up the funds with which a business firm finances its operations and its growth.

1. BASICS OF SOLVENCY (Cont.) EARNINGS POWER:

The recurring ability to generate cash from operations.

LOAN COVENANTS:

The protection against insolvency and financial distress. They define defaults to allow the opportunity to collect on a loan before severe distress.

FINANCIAL LEVERAGE:

The degree to which a business is utilizing borrowed money rather then equity to

fund it’s operations. It reflects the amount of debt used in the capital structure of

the firm.

1. BASICS OF SOLVENCY (Cont.) EARNINGS POWER:

The recurring ability to generate cash from operations.

LOAN COVENANTS:

The protection against insolvency and financial distress. They define defaults to allow the opportunity to collect on a loan before severe distress.

FINANCIAL LEVERAGE:

The degree to which a business is utilizing borrowed money rather then equity to

fund it’s operations. It reflects the amount of debt used in the capital structure of

the firm.

1. BASICS OF SOLVENCY (Cont.)

DEBT FINANCING:

Refers to any borrowed money which the entrepreneur must pay back to the lending institution. It can come in the form of a loan, line of credit, bond, or even an IOU. An interest rate and other terms apply.

EQUITY FINANCING:

This money lent in exchange for ownership in a company. New businesses can use equity financing for their start-ups or when they need to raise additional equity capital to offset existing debt.

CHARACTERISTICS OF DEBT AND EQUITY

EQUITY FINANCING DEBT FINANCINGReturn is subject to tax. Dividend is completely free from taxNo capital gain tax is applicable. It is applicable (short & long).No ownership on the company. Ownership is available.No capital growth possible. Capital growth is possible.Tenure of investment is always fixed. Not applicable.Quantum of returns is always fixed. Not applicable.Coupon rate & YTM are always variables. Not applicable.Frequency of return is possible. Not applicable.Nomenclature for the return is called Interest. The return in equity is called Dividend.

CAPITAL STRUCTURE

EQUITY DEBT

Personal Savings

Friends and Family

Other Individual Investors

Commercial Banks

Business Suppliers

Asset-Based Lenders

Government-Sponsored Programs

Venture Capital Firms

Community-Based Financial InstitutionsLarge Corporations

Public Sale of Stock

DEBT & EQUITY: SOURCES OF FINANCING

MERITS AND DEMERITS OF DEBT AND EQUITY FINANCING

DEBT FINANCINGMERITS DEMERITS

a)      Because the lender does not have a claim to equity in the business, debt does not dilute the owner's ownership interest in the company.

a)      Unlike equity, debt must at some point be repaid.

b)      A lender is entitled only to repayment of the agreed-upon principal of the loan plus interest, and has no direct claim on future profits of the business. If the company is successful, the owners reap a larger portion of the rewards than they would if they had sold stock in the company to investors in order to finance the growth.

b)      Interest is a fixed cost which raises the company's break-even point. High interest costs during difficult financial periods can increase the risk of insolvency. Companies that are too highly leveraged often find it difficult to grow because of high cost of servicing debt.

c)      Except in the case of variable rate loans, principal and interest obligations are known amounts which can be forecasted and planned for.

c)      Cash flow is required for both principal and interest payments and must be budgeted for. Most loans are not repayable in varying amounts over time based on the business cycles.

MERITS AND DEMERITS OF DEBT AND EQUITY FINANCING(Cont.)

DEBT FINANCING

MERITS DEMERITS

d)      Interest on the debt can be deducted on the company's tax return, lowering the actual cost of the loan to the company.

d)      Debt instruments often contain restrictions on the company's activities, prevents pursuit of alternative financing options and non-core business opportunities.

e)      Raising debt capital is less complicated because the company is not required to comply with state and federal securities laws and regulations.

e)      The larger a company's debt-equity ratio, the more risky the company. Accordingly, a business is limited as to the amount of debt it can carry.

f)        The company is not required to send periodic mailings to large numbers of investors, hold periodic meetings of shareholders, and seek the vote of shareholders before taking certain actions.

F) The company is usually required to pledge assets of the company to the lender as collateral, and owners of the company are in some cases required to personally guarantee repayment of the loan.

MERITS AND DEMERITS OF DEBT AND EQUITY FINANCING(Cont.)

EQUITY FINANCING

MERITS DEMERITS

a)      Lower risk. Generally, it’s less risky to use equity financing rather than take out a loan from a lender because you don’t have to pay equity back like you would a loan. Equity can a good option for businesses that aren’t in a place where they can take on additional debt.

a)      High returns. In order to persuade investors to invest, you may have to promise to pay higher returns than the rates you’d pay to a bank or other debtor if you took out a loan. Taking on such high returns can cripple many small businesses.

b)      Equity tends to increase your credibility. If you can successfully raise equity for your business, it will likely boost your business’ reputation, at least with investors. Your ability to tap into investor networks will likely lend to the credibility of your business venture.

b)      Giving up control of your business. When you raise financing through equity, you’re required to give up ownership, a percentage of profits, and, to some extent, control of the company. This is a difficult pill to swallow for many small business owners, especially those that have held onto control and ownership for a significant period of time.

MERITS AND DEMERITS OF DEBT AND EQUITY FINANCING(Cont.)

EQUITY FINANCINGMERITS DEMERITS

c)      Long-term equity vs. short-term debt. In most cases with equity, investors will take a long-term view of the business, i.e. they typically won’t expect a return on their investment anytime soon (the key word being “typically”).

c)      It complicates the decision-making process. Before you make big decisions with respect to your business, you’ll have to consult your investor-shareholders. This can be an administrative hassle, and especially difficult if you don’t see eye to eye on the decision.

d)      No repayments. With equity, you won’t have to budget for loan repayments out of your profits. Not having to budget a loan payment into your business’ monthly budget can mean the difference between the ability to hire additional employees to help grow your business.

d)      Extensive time and expenses. Finding the right investors for your company isn’t an easy task. It often takes a significant amount of time, effort, and money just to find the right investor.

e)      Increase Your Cash Flow. With equity, you’ll generally end up with more cash on hand that you can use for growing the business. Because investors are hoping to obtain a high return on their investment, they’ll generally prefer leaving their money in the business to help promote growth.

 

CONCEPT OF FINANCIAL LEVERAGE

Year 3 Safaritec Ltd Zaintec Ltdkes(millions) kes(millions)

Income before Interest and Taxes……………….…….200 200Interest (10% of 600)……………….……………………..-60 0Income before taxes……….………...………………….140 200Taxes(30%)……………………...……………………….-42 -60Net Income………………………...…………………….98 140

Add back Interest paid to bondholders………………..60 0Total return to Security holders(Debt& Equity)……………158 140

These two companies have identical net operating assets and operating income. Safaritec ltd derives 60% of its financing from debt while Zaintec ltd., is debt-free, or unlevered. Safaritec ltd has benefited from the tax benefits emanating from its leveraged position.

Hence Debt is cheaper than Equity as illustrated below:

Financial Leverage- Illustrating Tax Deductibility of Interest

CONCEPT OF FINANCIAL LEVERAGE(CONT.)

There are four positions which show a relationship with the level of financial leverage:-

1. The relation of equity and debt, for instance, the rate of capital. And the influences on business production and cycle of financial leverage.

2. The company's industry and branch whole financial leverage level.

3. The correlation between the current financial leverage ratio of the company and the middle leverage level.

4. The conformity of company's mission and philosophy with the situation connected to the relation of financial leverage.

2. CAPITAL STRUCTURE COMPOSITION & SOLVENCY

Common-Size Statements in Solvency AnalysisDone by constructing a common-size statement of the liabilities and equity section of the balance sheet. The exhibit below illustrates a common-size analysis for Daviranx Enterprises.

Current liabilities

29%

Long-term Debt3%

Prefered Stock25%

Common Stock33%

Paid-in Capital

3%

Retained Earnings

7%

Daviranx Enterprises Capital StructureCommon- Siza Analysis

kes %Current liabilities 520,000.00 29%Long-term Debt 60,000.00 3%Equity CapitalPrefered Stock 450,000.00 25%Common Stock 600,000.00 33%Paid-in Capital 60,000.00 3%Retained Earnings 125,000.00 7%Total Equity Caopital 1,235,000.00 68%Total Liabilities and Equity 1,815,000.00 100%

2. CAPITAL STRUCTURE COMPOSITION & SOLVENCY(CONT.)

Capital Structure Measures for Solvency AnalysisCapital structure ratios measures of capital structure relate components of capital structure to each other or their total.

1. Total Debt to Total Capital: Measures the relation between total Debt and Total Capital. Also Known as Total Debt Ratio

Total debt / Total capital

2. Total Debt to Equity Capital: Defined as; Total debt / Shareholders' equity

3. Long-Term Debt to Equity Capital: A ratio in excess of 1:1 indicates greater long-term debt financing compared to equity capital. Also known as Equity Ratio; Long-term debt / Shareholders’ equity

4. Short -Term Debt to Total Debt: Indicates firms reliance on Short-term financing-subject to frequent changes in interest rates

2. CAPITAL STRUCTURE COMPOSITION & SOLVENCY(CONT.)

Interpretation of Capital Structure Measures

Common-size and ratio analyses of capital structure are primarily measures of the risk of a company’s capital structure hence serve as screening devices.

Analysis of short-term liquidity is always important because before analysts assess long-term solvency as they want to be satisfied about the near-term financial survival of the company

Additional analytical tests of importance include the examination of debt maturities (as to amount and timing), interest costs, and risk-bearing factors.

2. CAPITAL STRUCTURE COMPOSITION & SOLVENCY(CONT.)

Asset-Based Measures of Solvency

The assets a company employs in its operating activities determine to some extent the sources of financing. These long-term assets are usually financed with equity capital.

Debt capital is also a common source of long-term asset financing, especially in industries like utilities where revenue sources are stable.

Asset composition analysis is an important tool in assessing the risk exposure of a company’s capital structure. Asset composition is typically evaluated using common-size statements of asset balances.

3. EARNINGS COVERAGERelation of Earnings to Fixed Charges

Earnings coverage measures focus on the relation between debt-related fixed charges and a company’s earnings available to meet these charges.

Bond indentures often specify minimum levels of earnings coverage for additional issuance of debt. The typical measure is:-

Earnings available for fixed charges / Fixed charges

The concept underlying this measure is straightforward. Yet application of this measure is complicated by what is included in both “earnings available for fixed charges” and “fixed charges.”

3. EARNINGS COVERAGE(CONT.)Computing Earnings Available for Fixed Charges

The intention in this analysis is to ensure that focus is on cash revenues. Analysis must recognize that unadjusted net income is not necessarily a good measure of cash available for fixed charges.

Using earnings as an approximation of cash from operations is sometimes appropriate while in others it can misstate the amount available for servicing fixed charges.

Our approach to this problem lies not with generalizations but in careful analysis of non-cash revenue and expense items that make up income.

Average earnings from continuing operations that span the business cycle and are adjusted for likely future changes are probably a good approximation of the average cash available from future operations to pay fixed charges.

If one objective of an earnings coverage ratio is to measure a creditor’s maximum exposure to risk, an appropriate earnings figure is one that occurs at the low point of the company’s business cycle.

3. EARNINGS COVERAGE(CONT.)COMPUTING FIXED CHARGES

Interest Incurred. Interest incurred is the most direct and obvious fixed charge arising from debt. We can approximate the amount of interest incurred by referring to the mandatory disclosure of interest paid in the statement of cash flows. Interest incurred differs from the reported interest paid due to reasons that include (1) changes in interest payable, (2) interest capitalized being netted, and (3) discount and premium amortization. In the absence of information, interest paid is a good approximation of interest incurred.

Interest Implicit in Lease Obligations. When a lease is capitalized, the interest portion of the lease payment is included in interest expense on the income statement, while most of the balance is usually considered repayment of the principal obligation. A question arises when our analysis discovers certain leases that should be capitalized but are not. This question goes beyond the accounting question of whether capitalization is appropriate or not. We must remember a long-term lease represents a fixed obligation that must be given recognition in computing the earnings to fixed charges ratio.

Preferred Stock Dividend Requirements of Majority-Owned Subsidiaries. These are viewed as fixed charges because they have priority over the distribution of earnings to the parent. Items that would be or are eliminated in consolidation should not be viewed as fixed charges. We must remember that all fixed charges not tax deductible must be tax adjusted. This is done by increasing them by an amount equal to the income tax required to yield an after-tax income sufficient to cover these fixed charges. The preferred stock dividend requirements of majority-owned subsidiaries are an example of a non tax- deductible fixed charge. We make an adjustment to compute the “gross” amount:

Preferred stock dividend requirements / 1 – Effective tax rate

3. EARNINGS COVERAGE(CONT.)COMPUTING FIXED CHARGES

Principal Repayment Requirements: Principal repayment obligations are from a cash outflow perspective as onerous as interest obligations. In the case of rental payments, a company’s obligations to pay principal and interest must be met simultaneously.

Guarantees to Pay Fixed Charges. Guarantees to pay fixed charges of unconsolidated subsidiaries or of unaffiliated persons (entities) should be added to fixed charges if the requirement to honor the guarantee appears imminent in the statement Analysis.

Other Fixed Charges. While interest payments and principal repayment requirements are the fixed charges most directly related to the incurrence of debt, there is no reason to restrict our analysis of long-term solvency to these charges or commitments. A thorough analysis of fixed charges should include all long-term rental payment obligations.

3. EARNINGS COVERAGE(CONT.)COMPUTING EARNINGS TO FIXED CHARGES

[(a) Pretax income from continuing operations plus (b) Interest expense plus (c) Amortization of debt expense and discount or premium plus (d )

Interest portion of operating rental expenses plus (e) Tax-adjusted preferred stock dividend requirements of majority-owned subsidiaries

plus ( f ) Amount of previously capitalized interest amortized in the period minus ( g ) Undistributed income of less than 50%-owned

subsidiaries or affiliates] / [(h) Total interest incurred plus (c ) Amortization of debt expense and discount or premium plus (d ) Interest

portion of operating rental expenses plus (e ) Tax-adjusted preferred stock dividend requirements of majority-owned subsidiaries]

3. EARNINGS COVERAGE(CONT.)COMPUTING EARNINGS TO FIXED CHARGES

Individual components in this ratio are labeled a–h and are further explained here:

a. Pretax income before discontinued operations, extraordinary items, and cumulative effects of accounting changes.

b. Interest incurred less interest capitalized.

c. Usually included in interest expense.

d. 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.

e. Excludes all items eliminated in consolidation. The dividend amount is increased to pretax earnings required to pay for it.

f. Applies to nonutility companies. This amount is not often disclosed.

g. Minority interest in income of majority-owned subsidiaries having fixed charges can be included in income.

h. Included whether expensed or capitalized.

3. EARNINGS COVERAGE(CONT.)TIMES INTEREST EARNED ANALYSIS

This ratio considers interest as the only fixed charge needing earnings coverage: The numerator in this ratio is sometimes referred to as earnings before interest and taxes, or EBIT, and then the ratio is referred to as EBIT/I.

It ignores most adjustments to both the numerator and denominator that we discussed with the earnings to fixed charges ratio.

[Income + Tax expense + Interest expense] / Interest expense

3. EARNINGS COVERAGE(CONT.)RELATION OF CASH FLOW TO FIXED CHARGES

Cash Flow to Fixed Charges Ratio: Computed using cash from operations rather than earnings in the numerator of the earnings to fixed charges ratio.

[Pretax operating cash flow + Adjustments (b ) through ( g ) defined on page xx] /Fixed charges

Earnings Coverage of Preferred Dividends: Our analysis of preferred stock often benefits from measuring the earnings coverage of preferred dividends. This analysis is similar to our analysis of how earnings cover debt related fixed charges.

[Pretax income + Adjustments (b) through ( g ) defined on page xx] / [Fixed charges+ (Preferred dividends/1 – Tax rate)]

3. EARNINGS COVERAGE(CONT.)INTERPRETING EARNINGS COVERAGE MEASURES

This provide us insight into the ability of a company to meet its fixed charges out of current earnings.

There exists a high correlation between earnings coverage measures and the default rate on debt—that is, the higher the coverage, the lower the default rate.

An increased yield rate on debt seldom compensates creditors for the risk of losing principal. If the likelihood of a company meeting its obligations through continuing operations is not high, creditors’ risk is substantial.

The more stable the earnings pattern of a company or industry, the lower is the acceptable earnings coverage measure.

3. EARNINGS COVERAGE(CONT.)CAPITAL STRUCTURE RISK AND RETURN

It is useful for us to consider recent developments in financial innovations for assessing the risk inherent in a company’s capital structure. A company can increase risks of equity holders by increasing leverage.

Another potential benefit of leverage is the tax deductibility of interest while dividends paid to equity holders are not tax deductible. Still, substitution of debt for equity yields a riskier capital structure. This is why bonds used to finance certain leveraged buyouts are called junk bonds.

A junk bond, unlike its high-quality counterpart, is part of a high-risk capital structure where its interest payments are minimally covered by earnings. Economic adversities rapidly jeopardize interest payments and principal of junk bonds. Junk bonds possess the risk of equity more so than the safety of debt.

4. BOND CREDIT RATINGS

The bond credit rating is a composite expression of judgment about the creditworthiness of the bond issuer and the quality of the specific security being rated.

A rating measures credit risk where credit risk is the probability of developments unfavorable to the interests of creditors.

This judgment of creditworthiness is expressed in a series of symbols reflecting degrees of credit risk.

4. BOND CREDIT RATINGS (CONT.)GRADES FROM STANDARD & POOR’S

1. AAA Bonds rated AAA are highest-grade obligations. They possess the highest degree of protection as to principal and interest. Marketwise, they move with interest rates and provide maximum safety.

2. AA Bonds rated AA also qualify as high-grade obligations and in the majority of instances differ little from AAA issues. prices move with the long term market.

3. A Bonds rated A are regarded as upper-medium grade. They have considerable investment strength but are not free from adverse effects of changes in economic and trade conditions. Interest and principal are regarded as safe. They reflect money rates in their price behavior, and to some extent economic conditions.

4. BBB Bonds rated BBB, or medium-grade category, are borderline between sound obligations and those where the speculative element begins to predominate. They have more asset coverage and are protected by satisfactory earnings. Their susceptibility to changing conditions necessitates constant monitoring. They respond more to business and trade conditions than to interest rates. This grade is the lowest that typically qualifies for commercial bank investment.

4. BOND CREDIT RATINGS (CONT.)GRADES FROM STANDARD & POOR’S

A major reason why debt securities are widely rated while equity securities are not is because there is far greater uniformity of approach and homogeneity of analytical measures in analyzing creditworthiness than in analyzing future market performance of equity securities.

This wider agreement on what is being measured in credit risk analysis has resulted in acceptance of and reliance on published credit ratings for several purposes.

4. BOND CREDIT RATINGS (CONT.)FACTORS TO CONSIDER WHEN RATING DEBT

1. Asset Protection: Refers to the extent a company’s debt is covered by its assets. One measure is net tangible assets to long-term debt.

2. Financial Resources: Refer to liquid resources like cash and working capital accounts. Analysis measures include the collection period of receivables and inventory turnover.

3. Future Earning Power: The level and quality of future earnings determine a company’s ability to meet its obligations, especially those of a long-term nature. Earning power is usually a more reliable source of protection than assets.

4. Management’s abilities: Foresight, philosophy, knowledge, experience, and integrity are important considerations in rating debt.

5. Debt provisions: Usually written in the bond indenture. Raters analyze the specific provisions in the indenture designed to protect interests of bondholders under a variety of conditions. These include analysis of stipulations (if any) for future debt issuances, security provisions like mortgaging, sinking funds, redemption provisions, and restrictive

4. BOND CREDIT RATINGS (CONT.)LIMITATIONS IN THE RATINGS GAME

Debt ratings are useful to a large proportion of debt issuances. Yet we must understand the inherent limitations of the standardized procedures of rating agencies. As with equity security analysis, our analysis can improve on these ratings. Debt issuances reflect a wide range of characteristics.

Consequently, they present us with opportunities to identify differences within rating classes and assess their favorable or unfavorable impact within their ratings class.

Also, there is evidence that rating changes lag the market. This lag effect presents us with additional opportunities to identify important changes prior to their being reported by rating agencies.

5. FINANCIAL DISTRESS

A common use of financial statement analysis is identifying areas needing further investigation and analysis.

One of these applications is predicting financial distress. Research has made substantial advances in suggesting various ratios as predictors of distress. This research is valuable in providing additional tools for analyzing long-term solvency.

Models of financial distress, commonly referred to as bankruptcy prediction models, examine the trend and behavior of selected ratios. Characteristics of these ratios are used in identifying the likelihood of future financial distress.

Models presume that evidence of distress appears in financial ratios and that we can detect it sufficiently early for us to take actions to either avoid risk of loss or to capitalize on this information.

5. FINANCIAL DISTRESS (CONT.)A LT M A N Z - S C O R E

It uses multiple ratios to generate a predictor of distress- a statistical technique (multiple discriminant analysis) to produce a predictor that is a linear function of several explanatory variables. This predictor classifies or predicts the likelihood of bankruptcy or nonbankruptcy. Five financial ratios are included in the Z-score:

X1 =Working capital/Total assets, X2 =Retained earnings/Total assets, X3 = Earnings before interest and taxes/Total assets, X4 = Shareholders’ equity/Total liabilities, and X5= Sales/Total assets.

5. FINANCIAL DISTRESS (CONT.)A LT M A N Z - S C O R E

We can view X1, X2, X3, X4, and X5 as respectively reflecting :-1. Liquidity, Firms with liquidity problems sometimes file for bankruptcy protection

to work out some arrangement with the creditors that will enable them to make their payments to the creditors under a little more favorable arrangement. A low proportion of liquid assets to total assets could be problematic for the company.

2. Age of firm and cumulative profitability, Signaling a pattern of lack of profitability or maybe an erosion of retained earnings due to recent net losses.

3. Profitability, Firms that declare bankruptcy are more likely to have had low earnings.

4. Financial structure, If low, reflects the fact that the company has a relatively high amount of debt—usually a bad situation for an unprofitable company.

5. Capital turnover rate, This ratio would be low for companies that are not effectively using their assets to produce sales

5. FINANCIAL DISTRESS (CONT.)A LT M A N Z - S C O R E

The Altman Z-score is computed as:

Z = 0.717 X1+ 0.847 X2+ 3.107 X3+ 0.420 X4+ 0.998 X5

A Z-score of less than 1.20 suggests a high probability of bankruptcy, while Z-scores above 2.90 imply a low probability of bankruptcy.

Scores between 1.20 and 2.90 are in the gray or ambiguous area.

THE END

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