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Chapter 16Chapter 16
Operating and Operating and Financial LeverageFinancial Leverage
Operating and Operating and Financial LeverageFinancial Leverage
© Pearson Education Limited 2004Fundamentals of Financial Management, 12/e
Created by: Gregory A. Kuhlemeyer, Ph.D.Carroll College, Waukesha, WI
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After studying Chapter 16, After studying Chapter 16, you should be able to:you should be able to:
Define operating and financial leverage and identify causes of both.
Calculate a firm’s operating break-even (quantity) point and break-even (sales) point .
Define, calculate, and interpret a firm's degree of operating, financial, and total leverage.
Understand EBIT-EPS break-even, or indifference, analysis, and construct and interpret an EBIT-EPS chart.
Define, discuss, and quantify “total firm risk” and its two components, “business risk” and “financial risk.”
Understand what is involved in determining the appropriate amount of financial leverage for a firm.
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Operating and Operating and Financial LeverageFinancial Leverage
Operating Leverage Financial Leverage Total Leverage Cash-Flow Ability to Service Debt Other Methods of Analysis Combination of Methods
16-4
Operating LeverageOperating Leverage
One potential “effect” caused by the presence of operating leverage is that a change in the volume of sales results in a “more than proportional” change in operating profit (or loss).
Operating Leverage Operating Leverage -- The use of -- The use of fixed operating costs by the firm.fixed operating costs by the firm.
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Impact of Operating Impact of Operating Leverage on ProfitsLeverage on Profits
Firm F Firm V Firm 2FFirm F Firm V Firm 2F
Sales $10 $11 $19.5Operating Costs
Fixed 7 2 14 Variable 2 7 3Operating Profit $$ 11 $ 2$ 2 $ 2.5 $ 2.5
FC/total costs .78 .22 .82 FC/sales .70 .18 .72
(in thousands)(in thousands)
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Impact of Operating Impact of Operating Leverage on ProfitsLeverage on Profits
Now, subject each firm to a 50% 50% increase in sales increase in sales for next year.
Which firm do you think will be more “sensitive” “sensitive” to the change in sales (i.e., show the largest percentage change in operating profit, EBIT)?
[ ] Firm FFirm F; [ ] Firm VFirm V; [ ] Firm 2FFirm 2F.
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Impact of Operating Impact of Operating Leverage on ProfitsLeverage on Profits
Firm F Firm V Firm 2FFirm F Firm V Firm 2F
Sales $15 $16.5 $29.25Operating Costs Fixed 7 2 14 Variable 3 10.5 4.5Operating Profit $$ 55 $ 4 $ 4 $10.75 $10.75
PercentagePercentage Change in EBITChange in EBIT* 400% 100% 330%400% 100% 330%
(in thousands)(in thousands)
* (EBITt - EBIT t-1) / EBIT t-1
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Impact of Operating Impact of Operating Leverage on ProfitsLeverage on Profits
Firm F Firm F is the most “sensitive” firm is the most “sensitive” firm -- for it, a 50% increase in sales leads to a 400% increase in EBIT400% increase in EBIT.
Our example reveals that it is a mistake to assume that the firm with the largest absolute or relative amount of fixed costs automatically shows the most dramatic effects of operating leverage.
Later, we will come up with an easy way to spot the firm that is most sensitive to the presence of operating leverage.
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Break-Even AnalysisBreak-Even Analysis
When studying operating leverage, “profits” refers to operating profits before taxes (i.e., EBIT) and excludes debt interest and dividend payments.
Break-Even Analysis Break-Even Analysis -- A technique for studying the relationship among fixed
costs, variable costs, sales volume, and profitsprofits. Also called cost/volume/profit
(C/V/P) analysis.
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Break-Even ChartBreak-Even Chart
QUANTITY PRODUCED AND SOLDQUANTITY PRODUCED AND SOLD
0 1,000 2,000 3,000 4,0004,000 5,000 6,000 7,000
Total RevenuesTotal Revenues
ProfitsProfits
Fixed CostsFixed Costs
Variable CostsVariable CostsLossesLosses
RE
VE
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AN
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RE
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AN
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($ t
ho
usa
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s)($
th
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175175
250
100
50
Total CostsTotal Costs
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Break-Even Break-Even (Quantity) Point(Quantity) Point
How to find the quantity break-even point:
EBIT = PP(QQ) - VV(QQ) - FCFC EBIT = QQ(PP - VV) - FCFC
P = Price per unitP = Price per unit V = Variable costs per unitV = Variable costs per unit FC = Fixed costs FC = Fixed costs Q = Quantity (units) Q = Quantity (units)
produced and soldproduced and sold
Break-Even Point Break-Even Point -- The sales volume required -- The sales volume required so that total revenues and total costs are so that total revenues and total costs are equal; may be in units or in sales dollars.equal; may be in units or in sales dollars.
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Break-Even Break-Even (Quantity) Point(Quantity) Point
Breakeven occurs when EBIT = 0
Q Q (PP - VV) - FCFC = EBIT
QQBE BE (PP - VV) - FCFC = 0
QQBE BE (PP - VV) = FCFC
QQBEBE = FCFC / (PP - VV) a.k.a. Unit Contribution Margin
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Break-Even (Sales) PointBreak-Even (Sales) Point
How to find the sales break-even point:
SSBEBE = FCFC + (VCVCBEBE)
SSBEBE = FC FC + (QQBEBE )(VV)
or
SSBE BE ** = FCFC / [1 - (VCVC / S) ]
* Refer to text for derivation of the formula
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Break-Even Break-Even Point ExamplePoint Example
Basket Wonders (BW) wants to determine both the quantity and sales quantity and sales
break-even points break-even points when: Fixed costs Fixed costs are $100,000$100,000
Baskets are sold for $43.75$43.75 eacheach
Variable costs are $18.75 per basket$18.75 per basket
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Break-Even Point (s)Break-Even Point (s)
Breakeven occurs when:
QQBEBE = FCFC / (PP - VV)
QQBEBE = $100,000$100,000 / ($43.75$43.75 - $18.75$18.75)
QQBEBE = 4,000 Units4,000 Units
SSBEBE = (QQBEBE )(VV) + FCFC
SSBEBE = (4,0004,000 )($18.75$18.75) + $100,000$100,000
SSBEBE = $175,000$175,000
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Break-Even ChartBreak-Even Chart
QUANTITY PRODUCED AND SOLDQUANTITY PRODUCED AND SOLD
0 1,000 2,000 3,000 4,0004,000 5,000 6,000 7,000
Total RevenuesTotal Revenues
ProfitsProfits
Fixed CostsFixed Costs
Variable CostsVariable CostsLossesLosses
RE
VE
NU
ES
AN
D C
OS
TS
RE
VE
NU
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AN
D C
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($ t
ho
usa
nd
s)($
th
ou
san
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175175
250
100
50
Total CostsTotal Costs
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Degree of Operating Degree of Operating Leverage (DOL)Leverage (DOL)
DOLDOL at Q units of output
(or sales)
Degree of Operating Leverage Degree of Operating Leverage -- The percentage change in a firm’s operating profit (EBIT) resulting from a 1 percent
change in output (sales).
=
Percentage change in operating profit (EBIT)
Percentage change in output (or sales)
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Computing the DOLComputing the DOL
DOLDOLQ unitsQ units
Calculating the DOL for a single product Calculating the DOL for a single product or a single-product firm.or a single-product firm.
=QQ (PP - VV)
QQ (PP - VV) - FCFC
QQ - QQBEBE
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Computing the DOLComputing the DOL
DOLDOLS dollars of salesS dollars of sales
Calculating the DOL for a Calculating the DOL for a multiproduct firm.multiproduct firm.
=SS - VCVC
SS - VCVC - FCFC
=EBIT + FCFC
EBIT
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Break-Even Break-Even Point ExamplePoint Example
Lisa Miller wants to determine the degree degree of operating leverage of operating leverage at sales levels of sales levels of
6,000 and 8,000 units6,000 and 8,000 units. As we did earlier, we will assume that:
Fixed costs Fixed costs are $100,000$100,000
Baskets are sold for $43.75$43.75 eacheach
Variable costs are $18.75 per basket$18.75 per basket
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Computing BW’s DOLComputing BW’s DOL
DOLDOL6,000 units6,000 units
Computation based on the previously Computation based on the previously calculated break-even point of 4,000 unitscalculated break-even point of 4,000 units
=6,0006,000
6,000 6,000 - 4,000 4,000
=
= 33
DOLDOL8,000 units8,000 units
8,0008,0008,000 8,000 - 4,000 4,000
= 22
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Interpretation of the DOLInterpretation of the DOL
A 1% increase in sales above the 8,000 A 1% increase in sales above the 8,000 unit level increases EBIT by 2% unit level increases EBIT by 2%
because of the existing operating because of the existing operating leverage of the firm.leverage of the firm.
=DOLDOL8,000 units8,000 units
8,0008,0008,000 8,000 - 4,000 4,000
= 22
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Interpretation of the DOLInterpretation of the DOL
2,000 2,000 4,0004,000 6,000 8,000 6,000 8,000
1122334455
QUANTITY PRODUCED AND SOLDQUANTITY PRODUCED AND SOLD
00-1-1-2-2-3-3
-4-4-5-5
DE
GR
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OF
OP
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DE
GR
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OF
OP
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LE
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(D
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)L
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AG
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DO
L)
QQBEBE
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Interpretation of the DOLInterpretation of the DOL
DOL is a quantitative measure of the “sensitivity” of a firm’s operating profit to a change in the firm’s sales.
The closer that a firm operates to its break-even point, the higher is the absolute value of its DOL.
When comparing firms, the firm with the highest DOL is the firm that will be most “sensitive” to a change in sales.
Key Conclusions to be Drawn from the Key Conclusions to be Drawn from the previous slide and our Discussion of DOLprevious slide and our Discussion of DOL
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DOL and Business RiskDOL and Business Risk
DOL is only one component one component of business risk and becomes “active” only in the presence only in the presence of sales and production cost variabilityof sales and production cost variability.
DOL magnifiesmagnifies the variability of operating profits and, hence, business risk.
Business Risk Business Risk -- The inherent uncertainty -- The inherent uncertainty in the physical operations of the firm. Its in the physical operations of the firm. Its impact is shown in the variability of the impact is shown in the variability of the
firm’s operating income (EBIT).firm’s operating income (EBIT).
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Application of DOL for Application of DOL for Our Three Firm ExampleOur Three Firm Example
Use the data in Slide 16-5 and the Use the data in Slide 16-5 and the following formula for following formula for Firm FFirm F::
DOLDOL = [( = [(EBITEBIT + + FCFC)/)/EBITEBIT]]
=DOLDOL$10,000 sales$10,000 sales
1,000 1,000 ++ 7,0007,0001,0001,000
= 8.08.0
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Application of DOL for Application of DOL for Our Three Firm ExampleOur Three Firm Example
Use the data in Slide 16-5 and the Use the data in Slide 16-5 and the following formula for following formula for Firm VFirm V::
DOLDOL = [( = [(EBITEBIT + + FCFC)/)/EBITEBIT]]
=DOLDOL$11,000 sales$11,000 sales
2,000 2,000 ++ 2,0002,0002,0002,000
= 2.02.0
16-28
Application of DOL for Application of DOL for Our Three-Firm ExampleOur Three-Firm Example
Use the data in Slide 16-5 and the Use the data in Slide 16-5 and the following formula for following formula for Firm 2FFirm 2F::
DOLDOL = [( = [(EBITEBIT + + FCFC)/)/EBITEBIT]]
=DOLDOL$19,500 sales$19,500 sales
2,500 2,500 ++ 14,00014,0002,5002,500
= 6.66.6
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Application of DOL for Application of DOL for Our Three-Firm ExampleOur Three-Firm Example
The ranked results indicate that the firm most The ranked results indicate that the firm most sensitive to the presence of operating leverage sensitive to the presence of operating leverage
is is Firm FFirm F.
Firm FFirm F DOLDOL = = 8.08.0Firm VFirm V DOLDOL = = 6.66.6Firm 2FFirm 2F DOLDOL = = 2.02.0
Firm FFirm F will expect a will expect a 400% increase in profit400% increase in profit from a from a 50% 50% increase in salesincrease in sales (see Slide 16-7 results). (see Slide 16-7 results).
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Financial LeverageFinancial Leverage
Financial leverage is acquired by choice.
Used as a means of increasing the return to common shareholders.
Financial Leverage Financial Leverage -- The use of -- The use of fixed financing costs by the firm. fixed financing costs by the firm. The British expression is The British expression is gearinggearing..
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EBIT-EPS Break-Even, EBIT-EPS Break-Even, or Indifference, Analysisor Indifference, Analysis
Calculate EPS EPS for a given level of EBITEBIT at a given financing structure.
EBIT-EPS Break-Even Analysis EBIT-EPS Break-Even Analysis -- Analysis -- Analysis of the effect of financing alternatives on of the effect of financing alternatives on
earnings per share. The break-even point is earnings per share. The break-even point is the EBIT level where EPS is the same for the EBIT level where EPS is the same for
two (or more) alternatives.two (or more) alternatives.
(EBITEBIT - I) (1 - t) - Pref. Div.
# of Common SharesEPSEPS =
16-32
EBIT-EPS ChartEBIT-EPS Chart
Current common equity shares = 50,000Current common equity shares = 50,000 $1 million in new financing of either:$1 million in new financing of either:
All C.S. sold at $20/share (50,000 shares) All debt with a coupon rate of 10% All P.S. with a dividend rate of 9%
Expected EBIT = $500,000Expected EBIT = $500,000 Income tax rate is 30%Income tax rate is 30%
Basket Wonders Basket Wonders has $2 million in LT financing has $2 million in LT financing (100% common stock equity).(100% common stock equity).
16-33
EBIT-EPS Calculation with EBIT-EPS Calculation with New Equity FinancingNew Equity Financing
EBITEBIT $500,000 $500,000 $150,000 $150,000*Interest 0 0EBT $500,000 $150,000Taxes (30% x EBT) 150,000 45,000EAT $350,000 $105,000Preferred Dividends 0 0EACS EACS $350,000 $350,000 $105,000 $105,000# of Shares 100,000 100,000EPSEPS $3.50 $3.50 $1.05 $1.05
Common Stock Equity AlternativeCommon Stock Equity Alternative
* A second analysis using $150,000 EBIT rather than the expected EBIT.
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EBIT-EPS ChartEBIT-EPS Chart
0 100 200 300 400 500 600 7000 100 200 300 400 500 600 700
EBIT ($ thousands)EBIT ($ thousands)
Ear
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Sh
are
($)
Ear
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($)
00
11
22
33
44
55
66
CommonCommon
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EBIT-EPS Calculation with EBIT-EPS Calculation with New Debt FinancingNew Debt Financing
EBITEBIT $500,000 $500,000 $150,000 $150,000*Interest 100,000 100,000EBT $400,000 $ 50,000Taxes (30% x EBT) 120,000 15,000EAT $280,000 $ 35,000Preferred Dividends 0 0EACS EACS $280,000 $280,000 $ 35,000 $ 35,000# of Shares 50,000 50,000EPSEPS $5.60 $5.60 $0.70 $0.70
Long-term Debt AlternativeLong-term Debt Alternative
* A second analysis using $150,000 EBIT rather than the expected EBIT.
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EBIT-EPS ChartEBIT-EPS Chart
0 100 200 300 400 500 600 7000 100 200 300 400 500 600 700
EBIT ($ thousands)EBIT ($ thousands)
Ear
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($)
Ear
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($)
00
11
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33
44
55
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CommonCommon
DebtDebt
Indifference pointbetween debtdebt and
common stockcommon stockfinancing
16-37
EBIT-EPS Calculation with EBIT-EPS Calculation with New Preferred FinancingNew Preferred Financing
EBITEBIT $500,000 $500,000 $150,000 $150,000*Interest 0 0EBT $500,000 $150,000Taxes (30% x EBT) 150,000 45,000EAT $350,000 $105,000Preferred Dividends 90,000 90,000EACS EACS $260,000 $260,000 $ 15,000 $ 15,000# of Shares 50,000 50,000EPSEPS $5.20 $5.20 $0.30 $0.30
Preferred Stock AlternativePreferred Stock Alternative
* A second analysis using $150,000 EBIT rather than the expected EBIT.
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0 100 200 300 400 500 600 7000 100 200 300 400 500 600 700
EBIT-EPS ChartEBIT-EPS Chart
EBIT ($ thousands)EBIT ($ thousands)
Ear
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($)
Ear
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($)
00
11
22
33
44
55
66
CommonCommon
DebtDebt
Indifference pointbetween preferred preferred stock stock and common common
stockstock financing
PreferredPreferred
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What About Risk?What About Risk?
0 100 200 300 400 500 600 7000 100 200 300 400 500 600 700
EBIT ($ thousands)EBIT ($ thousands)
Ear
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Sh
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($)
Ear
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00
11
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CommonCommon
DebtDebt
Lower riskLower risk. Only a smallprobability that EPS willbe less if the debtalternative is chosen.
Pro
bab
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ccurren
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rob
ability o
f Occu
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(for th
e pro
bab
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(for th
e pro
bab
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What About Risk?What About Risk?
0 100 200 300 400 500 600 7000 100 200 300 400 500 600 700
EBIT ($ thousands)EBIT ($ thousands)
Ear
nin
gs
per
Sh
are
($)
Ear
nin
gs
per
Sh
are
($)
00
11
22
33
44
55
66
CommonCommon
DebtDebt
Higher riskHigher risk. A much largerprobability that EPS willbe less if the debtalternative is chosen.
Pro
bab
ility of O
ccurren
ceP
rob
ability o
f Occu
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(for th
e pro
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(for th
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Degree of Financial Degree of Financial Leverage (DFL)Leverage (DFL)
DFLDFL at EBIT of
X dollars
Degree of Financial Leverage Degree of Financial Leverage -- The percentage change in a firm’s earnings
per share (EPS) resulting from a 1 percent change in operating profit.
=
Percentage change in earnings per share (EPS)
Percentage change in operating profit (EBIT)
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Computing the DFLComputing the DFL
DFLDFL EBIT of $X
Calculating the DFLCalculating the DFL
=EBITEBIT
EBIT EBIT - II - [ PDPD / (1 - tt) ]
EBIT EBIT = Earnings before interest and taxes= Earnings before interest and taxesI I = Interest= InterestPD PD = Preferred dividends= Preferred dividendst t = Corporate tax rate= Corporate tax rate
16-43
What is the DFL for Each What is the DFL for Each of the Financing Choices?of the Financing Choices?
DFLDFL $500,000$500,000
Calculating the DFL for Calculating the DFL for NEWNEW equity equity* alternativealternative
=$500,000$500,000
$500,000 $500,000 - 00 - [00 / (1 - 00)]
* The calculation is based on the expected EBIT
= 1.001.00
16-44
What is the DFL for Each What is the DFL for Each of the Financing Choices?of the Financing Choices?
DFLDFL $500,000$500,000
Calculating the DFL for Calculating the DFL for NEWNEW debt debt * alternativealternative
=$500,000$500,000
{{ $500,000 $500,000 - 100,000100,000 - [00 / (1 - 00)] }
* The calculation is based on the expected EBIT
= $500,000$500,000 / $400,000
1.251.25=
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What is the DFL for Each What is the DFL for Each of the Financing Choices?of the Financing Choices?
DFLDFL $500,000$500,000
Calculating the DFL for Calculating the DFL for NEWNEW preferred preferred * alternativealternative
=$500,000$500,000
{{ $500,000 $500,000 - 0 0 - [90,00090,000 / (1 - .30.30)] }
* The calculation is based on the expected EBIT
= $500,000$500,000 / $400,000
1.351.35=
16-46
Variability of EPSVariability of EPS
Preferred stock Preferred stock financing will lead to the greatest variability in earnings per share based on the DFL.
This is due to the tax deductibility of interest on debt financing.
DFLDFLEquityEquity = 1.00 = 1.00
DFLDFLDebtDebt = 1.25 = 1.25
DFLDFLPreferredPreferred = = 1.351.35
Which financing method will have
the greatest relative greatest relative variability in EPS?variability in EPS?
16-47
Financial RiskFinancial Risk
Debt increases the probability of cash insolvency over an all-equity-financed firm. For example, our example firm must have EBIT of at least $100,000 to cover the interest payment.
Debt also increased the variability in EPS as the DFL increased from 1.00 to 1.25.
Financial Risk Financial Risk -- The added variability in -- The added variability in earnings per share (EPS) -- plus the risk of earnings per share (EPS) -- plus the risk of
possible insolvency -- that is induced by the possible insolvency -- that is induced by the use of financial leverage.use of financial leverage.
16-48
Total Firm RiskTotal Firm Risk
CVCVEPSEPS is a measure of relative total firm risktotal firm risk
CVCVEBITEBIT is a measure of relative business riskbusiness risk
The difference, CVCVEPSEPS - CV - CVEBITEBIT, is a measure of relative financial riskfinancial risk
Total Firm Risk Total Firm Risk -- The variability in earnings per -- The variability in earnings per share (EPS). It is the sum of business plus share (EPS). It is the sum of business plus
financial risk.financial risk.
Total firm risk Total firm risk = business risk business risk + financial riskfinancial risk
16-49
Degree of Total Degree of Total Leverage (DTL)Leverage (DTL)
DTLDTL at Q units (or S dollars) of output (or
sales)
Degree of Total Leverage Degree of Total Leverage -- The percentage change in a firm’s earnings
per share (EPS) resulting from a 1 percent change in output (sales).
=
Percentage change in earnings per share (EPS)
Percentage change in output (or sales)
16-50
Computing the DTLComputing the DTL
DTLDTL S dollars
of sales
DTLDTL Q units (or S dollars) Q units (or S dollars) = ( DOL DOL Q units (or S dollars) Q units (or S dollars) ) x ( DFLDFL EBIT of X dollars EBIT of X dollars )
=EBITEBIT + FC
EBIT EBIT - II - [ PDPD / (1 - tt) ]
DTLDTL Q unitsQQ (PP - - VV)
QQ (PP - - VV) - FC - II - [ PDPD / (1 - tt) ]=
16-51
DTL ExampleDTL Example
Lisa Miller wants to determine the Degree of Total Leverage Degree of Total Leverage at
EBIT=$500,000. EBIT=$500,000. As we did earlier, we will assume that:
Fixed costs Fixed costs are $100,000$100,000
Baskets are sold for $43.75$43.75 eacheach
Variable costs are $18.75 per basket$18.75 per basket
16-52
Computing the DTL Computing the DTL for All-Equity Financingfor All-Equity Financing
DTLDTL S dollars
of sales
=$500,000$500,000 + $100,000
$500,000 $500,000 - 00 - [ 00 / (1 - .3.3) ]
DTLDTLS dollars S dollars = (DOLDOL S dollars S dollars) x (DFLDFLEBIT of $S EBIT of $S )
DTLDTLS dollars S dollars = (1.2 1.2 ) x ( 1.01.0* ) = 1.201.20
= 1.201.20*Note: No financial leverage.
16-53
Computing the DTL Computing the DTL for Debt Financingfor Debt Financing
DTLDTL S dollars
of sales
=$500,000$500,000 + $100,000
{ $500,000 $500,000 - $100,000$100,000 - [ 00 / (1 - .3.3) ] }
DTLDTLS dollars S dollars = (DOLDOL S dollars S dollars) x (DFLDFLEBIT of $S EBIT of $S )
DTLDTLS dollars S dollars = (1.2 1.2 ) x ( 1.251.25* ) = 1.501.50
= 1.501.50*Note: Calculated on Slide 16-44.
16-54
Risk versus ReturnRisk versus Return
Compare the expected EPS to the DTL for the common stock equity financing
approach to the debt financing approach.
FinancingFinancing E(EPS)E(EPS) DTLDTL
EquityEquity $3.50$3.50 1.201.20 DebtDebt $5.60$5.60 1.501.50
Greater expected return (higher EPS) comes at Greater expected return (higher EPS) comes at the expense of greater potential risk (higher DTL)!the expense of greater potential risk (higher DTL)!
16-55
What is an Appropriate What is an Appropriate Amount of Financial Leverage?Amount of Financial Leverage?
Firms must first analyze their expected future expected future cash flows.cash flows.
The greater greater and more stable more stable the expected future cash flows, the greater the debt capacity.the greater the debt capacity.
Fixed charges includeFixed charges include: debt principal and interest payments, lease payments, and preferred stock dividends.
Debt Capacity Debt Capacity -- The maximum amount of debt -- The maximum amount of debt (and other fixed-charge financing) that a firm (and other fixed-charge financing) that a firm
can adequately service.can adequately service.
16-56
Coverage RatiosCoverage RatiosCoverage RatiosCoverage Ratios
Interest CoverageInterest Coverage
EBITEBITInterest expensesInterest expenses
Interest CoverageInterest Coverage
EBITEBITInterest expensesInterest expenses
Indicates a firm’s ability to cover
interest charges.
Income StatementRatios
Coverage Ratios
A ratio value equal to 1indicates that earnings
are just sufficient tocover interest charges.
16-57
Coverage RatiosCoverage RatiosCoverage RatiosCoverage Ratios
Debt-service CoverageDebt-service Coverage
EBITEBIT{ Interest expensesInterest expenses +
[Principal payments / (1-t) Principal payments / (1-t) ] }
Debt-service CoverageDebt-service Coverage
EBITEBIT{ Interest expensesInterest expenses +
[Principal payments / (1-t) Principal payments / (1-t) ] }
Indicates a firm’s ability to cover
interest expenses and principal payments.
Income StatementRatios
Coverage Ratios
Allows us to examine theability of the firm to meetall of its debt payments.Failure to make principalpayments is also default.
16-58
Coverage ExampleCoverage Example
Make an examination of the coverage coverage ratiosratios for Basket Wonders when
EBIT=$500,000. EBIT=$500,000. Compare the equity and the debt financing alternatives.
Assume thatAssume that: Interest expensesInterest expenses remain at $100,000$100,000
Principal payments of $100,000Principal payments of $100,000 are made yearly for 10 years
16-59
Coverage ExampleCoverage Example
Compare the interest coverage and debt burden ratios for equity and debt financing.
Interest Interest Debt-service Debt-service FinancingFinancing CoverageCoverage Coverage Coverage
EquityEquity Infinite Infinite Infinite Infinite DebtDebt 5.00 5.00 2.50 2.50The firm actually has greater risk than the interest The firm actually has greater risk than the interest
coverage ratio initially suggests.coverage ratio initially suggests.
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Coverage ExampleCoverage Example
-250 0 250 500 750 1,000 1,250-250 0 250 500 750 1,000 1,250
EBIT ($ thousands)EBIT ($ thousands)
Firm B has a much smaller probability
of failing to meet its obligations than Firm A.
Firm BFirm B
Firm AFirm A
Debt-service burdenDebt-service burden= $200,000= $200,000
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Summary of the Coverage Summary of the Coverage Ratio DiscussionRatio DiscussionSummary of the Coverage Summary of the Coverage Ratio DiscussionRatio Discussion
A single ratio value cannot be interpreted identically for all firms as some firms have greater debt capacity.
Annual financial lease payments should be added to both the numerator and denominator of the debt-service coverage ratio as financial leases are similar to debt.
A single ratio value cannot be interpreted identically for all firms as some firms have greater debt capacity.
Annual financial lease payments should be added to both the numerator and denominator of the debt-service coverage ratio as financial leases are similar to debt.
The debt-service coverage ratio accounts for required annual principal payments.
The debt-service coverage ratio accounts for required annual principal payments.
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Other Methods of AnalysisOther Methods of Analysis
Often, firms are compared to peer institutions in the same industry.
Large deviations from norms must be justified.
For example, an industry’s median debt-to-net-worth ratio might be used as a benchmark for financial leverage comparisons.
Capital Structure Capital Structure -- The mix (or proportion) of a -- The mix (or proportion) of a firm’s permanent long-term financing firm’s permanent long-term financing
represented by debt, preferred stock, and represented by debt, preferred stock, and common stock equity.common stock equity.
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Other Methods of AnalysisOther Methods of Analysis
Firms may gain insight into the financial markets’ evaluation of their firm by talking with:
Investment bankers Institutional investors Investment analysts Lenders
Surveying Investment Analysts and LendersSurveying Investment Analysts and Lenders