Analyzing Long-Term Solvency Risk
As discussed above in the context of financial flexibility, financial leverage enhances ROCE when firms borrow funds and invest those funds in assets that generate a higher return than the after-tax cost of borrowing. Common shareholders benefit with increasing proportions of debt in the capital structure as long as the firm maintains ROA in excess of the after-tax cost of the debt. However, increasing the proportion of debt in the capital structure increases the risk that the firm cannot pay interest and repay the principal on the amount borrowed. That is, as credit and bankruptcy risk increases, and the incremental cost of borrowing is also likely to increase. The analysis of long-term solvency risk highlights a firm’s ability to make interest and principal payments on long-term debt and similar obligations as they come due.
A firm’s ability to generate earnings over a period of years is the best indicator for assessing long-term solvency risk. Profitable firms generate sufficient cash from operations, but also are able to obtain needed cash from creditors or equity investors. Therefore, the measures of profitability discussed in Chapter 4 in the context of analyzing ROA and ROCE are also useful in assessing long-term solvency risk.
As discussed above in the context of financial flexibility, financial leverage enhances ROCE when firms borrow funds and invest those funds in assets that generate a higher return than the after-tax cost of borrowing. Common shareholders benefit with increasing proportions of debt in the capital structure as long as the firm maintains ROA in excess of the after-tax cost of the debt. However, increasing the proportion of debt in the capital structure increases the risk that the firm cannot pay interest and repay the principal on the amount borrowed. That is, as credit and bankruptcy risk increases, and the incremental cost of borrowing is also likely to increase. The analysis of long-term solvency risk highlights a firm’s ability to make interest and principal payments on long-term debt and similar obligations as they come due.
A firm’s ability to generate earnings over a period of years is the best indicator for assessing long-term solvency risk. Profitable firms generate sufficient cash from operations, but also are able to obtain needed cash from creditors or equity investors. Therefore, the measures of profitability discussed in Chapter 4 in the context of analyzing ROA and ROCE are also useful in assessing long-term solvency risk.
Three measures are used in examining long-term solvency risk:
1. Debt ratios
2. Interest coverage ratios
3. Operating cash flow to total liabilities ratio
Debt Ratios
Debt ratios measure the relative amount of liabilities, particularly long-term debt, in a firm’s capital structure. The higher a debt ratio, the greater is the long-term solvency risk. components of ROCE, is one version of a debt ratio Several additional variations in debt ratios exist, including the following four common measures
1. Debt ratios
2. Interest coverage ratios
3. Operating cash flow to total liabilities ratio
Debt Ratios
Debt ratios measure the relative amount of liabilities, particularly long-term debt, in a firm’s capital structure. The higher a debt ratio, the greater is the long-term solvency risk. components of ROCE, is one version of a debt ratio Several additional variations in debt ratios exist, including the following four common measures
Exhibit 5.11 shows the debt ratios for PepsiCo at the end of 2010, 2011, and 2012. The median firm has a liabilities to equity ratio of approximately 1, and hence a liabilities to assets ratio of approximately 0.5. PepsiCo’s debt ratios are somewhat higher than these, which is to be expected given PepsiCo’s size, profitability, and strong capacity for debt financing. The debt ratios involving total liabilities exhibit a slight decrease from 2010 to the end of 2012. The same is true for the long-term debt ratios, although the pattern is more steadily decreasing. This is consistent with the insights generated in the previous discussion of trends in financial flexibility for PepsiCo.
Note the high correlations between changes in the two debt ratios involving total liabilities over time and in the two long-term debt ratios over time. These results are not surprising because they use overlapping financial statement data. Generally, you can select one of these ratios without losing much information based on an armada of similar ratios. Because different debt ratios exist, you should use caution when reading financial periodicals and discussing debt ratios with others, because variations in definitions are pervasive. For example, a liabilities to shareholders’ equity ratio greater than 1.0 (that is, more liabilities than shareholders’ equity) is not unusual, but a liabilities to assets ratio or a long-term debt to long-term capital ratio greater than 1.0 is highly unusual (because it requires a negative shareholders’ equity
In addition to computing debt ratios, you may gather information from the financial statement footnote on long-term debt. The note includes information on the types of debt a firm has issued and their interest rates and maturity dates. In certain situations, it is necessary to access public filings of debt contracts to monitor the firm’s closeness to debt covenants. PepsiCo’s Note , ‘‘Debt Obligations and Commitments’’ (Appendix A) provides information about the schedule of long-term debt obligations as well as significant issuances. During 2012, PepsiCo issued over $5 billion of senior notes payable, with the proceeds being used for ‘‘general corporate purposes, including the repayment of commercial paper.’’
In an effort to appear less risky and to lower their cost of financing or perhaps to avoid violating debt covenants in existing borrowing arrangements, some firms attempt to structure financing in a manner that keeps debt off the balance sheet. For example, companies often structure leases to qualify as operating leases instead of capital leases to minimize reported long-term debt
In addition to computing debt ratios, you may gather information from the financial statement footnote on long-term debt. The note includes information on the types of debt a firm has issued and their interest rates and maturity dates. In certain situations, it is necessary to access public filings of debt contracts to monitor the firm’s closeness to debt covenants. PepsiCo’s Note , ‘‘Debt Obligations and Commitments’’ (Appendix A) provides information about the schedule of long-term debt obligations as well as significant issuances. During 2012, PepsiCo issued over $5 billion of senior notes payable, with the proceeds being used for ‘‘general corporate purposes, including the repayment of commercial paper.’’
In an effort to appear less risky and to lower their cost of financing or perhaps to avoid violating debt covenants in existing borrowing arrangements, some firms attempt to structure financing in a manner that keeps debt off the balance sheet. For example, companies often structure leases to qualify as operating leases instead of capital leases to minimize reported long-term debt
No comments:
Post a Comment