Capacity for Debt
Closely related to a firm’s cash-generating ability and available collateral is a firm’s capacity to assume additional debt, discussed earlier as financial flexibility. The cash flows and the collateral represent the means to repay the debt. Most firms do not borrow up to the limit of their debt capacity, and lenders like to see a ‘‘margin of safety.’’ In addition to the factors discussed as part of financial flexibility, footnote disclosures highlight the amount of unused credit lines, which provide additional, direct evidence of capacity for debt.
Debt Ratios
Earlier, we described several ratios that relate the amount of long-term debt or total liabilities to shareholders’ equity or total assets as measures of the proportion of liabilities in the capital structure. In general, the higher the debt ratios, the higher the credit risk and the lower the unused debt capacity of the firm. When measuring debt ratios, you must be careful to consider possible off-balance-sheet obligations (such as operating lease commitments or underfunded pension or health care benefit obligations
Interest Coverage Ratio
the number of times interest payments are covered by operating income before interest and income taxes serves as a gauge of the margin of safety provided by operations to service debt. When the interest coverage ratio falls below approximately 2, the credit risk is generally considered high Contingencies The credit standing of a firm can change abruptly if current uncertainties turn out negatively for the firm. Thus, you should assess the likelihood that contingent outcomes occur. The following are examples:
Closely related to a firm’s cash-generating ability and available collateral is a firm’s capacity to assume additional debt, discussed earlier as financial flexibility. The cash flows and the collateral represent the means to repay the debt. Most firms do not borrow up to the limit of their debt capacity, and lenders like to see a ‘‘margin of safety.’’ In addition to the factors discussed as part of financial flexibility, footnote disclosures highlight the amount of unused credit lines, which provide additional, direct evidence of capacity for debt.
Debt Ratios
Earlier, we described several ratios that relate the amount of long-term debt or total liabilities to shareholders’ equity or total assets as measures of the proportion of liabilities in the capital structure. In general, the higher the debt ratios, the higher the credit risk and the lower the unused debt capacity of the firm. When measuring debt ratios, you must be careful to consider possible off-balance-sheet obligations (such as operating lease commitments or underfunded pension or health care benefit obligations
Interest Coverage Ratio
the number of times interest payments are covered by operating income before interest and income taxes serves as a gauge of the margin of safety provided by operations to service debt. When the interest coverage ratio falls below approximately 2, the credit risk is generally considered high Contingencies The credit standing of a firm can change abruptly if current uncertainties turn out negatively for the firm. Thus, you should assess the likelihood that contingent outcomes occur. The following are examples:
- Is the firm a defendant in a major lawsuit involving its principal products, its technological advantages, its income tax returns, or other core endeavors that could change its profitability and cash flows in the future? Most large firms are continually engaged in lawsuits as a normal part of their business, and most related losses are insured. Negative legal judgments are likely to have a more pronounced effect on smaller firms, however, because they have less of a resource base with which to defend themselves and to sustain such losses and may not carry adequate insurance.
- Has the firm sold receivables with recourse or served as guarantor on a loan by a subsidiary, joint venture, special-purpose entity, or corporate officer that, ifpayment is required, will consume cash flows otherwise available to service other debt obligations Is the firm exposed to making payments related to derivative financial instruments that could adversely affect future cash flows if interest rates, exchange rates, or other prices change significantly in an unexpected direction?
- Is the firm dependent on one or a few key employees, contracts or license agreements, or technologies, the loss of which could substantially affect the viability of the business? Obtaining answers to such questions requires you to read the notes to the financial statement carefully and to ask astute questions of management, attorneys, and others.
Character of Management
An intangible that can offset to some extent otherwise weak signals about the creditworthiness of a firm is the character of its management. Has the management team successively weathered previous operating problems and challenges that could have bankrupted most firms? Has the management team delivered in the past on projections regarding sales levels, cost reductions, new product development, and similar operating
An intangible that can offset to some extent otherwise weak signals about the creditworthiness of a firm is the character of its management. Has the management team successively weathered previous operating problems and challenges that could have bankrupted most firms? Has the management team delivered in the past on projections regarding sales levels, cost reductions, new product development, and similar operating
Communication
Developing relationships with lenders requires effective communication at the outset and on an ongoing basis. If lenders are unfamiliar with the business or its managers, efforts must be directed at communicating the nature of the firm’s products and services and the strategies the firm pursues to gain competitive advantage. Throughout the term of a loan, borrowing firms are frequently required to communicate regularly with lenders.
Conditions or Covenants
Lenders often place restrictions, or constraints, on a firm to protect their interests. These are referred to in the banking industry as covenants. Such restrictions might include minimum or maximum levels of certain financial ratios. For example, the current ratio cannot fall below 1.2 and the long-term debt to shareholders’ equity ratio cannot exceed 75%. Firms also may be precluded from paying dividends, repurchasing common stock, or taking on new financing with rights senior to existing lenders in the even of bankruptcy. Violation of such covenants could result in the need to repay loansimmediately, higher interest rates, or other burdensome restrictions
Developing relationships with lenders requires effective communication at the outset and on an ongoing basis. If lenders are unfamiliar with the business or its managers, efforts must be directed at communicating the nature of the firm’s products and services and the strategies the firm pursues to gain competitive advantage. Throughout the term of a loan, borrowing firms are frequently required to communicate regularly with lenders.
Conditions or Covenants
Lenders often place restrictions, or constraints, on a firm to protect their interests. These are referred to in the banking industry as covenants. Such restrictions might include minimum or maximum levels of certain financial ratios. For example, the current ratio cannot fall below 1.2 and the long-term debt to shareholders’ equity ratio cannot exceed 75%. Firms also may be precluded from paying dividends, repurchasing common stock, or taking on new financing with rights senior to existing lenders in the even of bankruptcy. Violation of such covenants could result in the need to repay loansimmediately, higher interest rates, or other burdensome restrictions
No comments:
Post a Comment