Lecture 5 Financial Analysis PDF

© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ...

© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.  Chapter 5 Long-Term Debt-Paying Ability © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Learning objectives Understand the concept of long-term debt-paying ability: - Define long-term debt and its significance in a company’s financial structure. - Explain why long-term debt-paying ability is important for creditors, investors, and management. Analyze key financial ratios used to assess long-term debt-paying ability: - Calculate and interpret the Debt to Equity Ratio, Times Interest Earned (TIE) Ratio, and the Debt to Tangible Net Worth Ratio. - Evaluate a company’s ability to meet long-term obligations using the Fixed Charge Coverage Ratio. © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Definition Long-term debt refers to loans and financial obligations that a company is required to pay back over a period greater than one year. This type of debt includes instruments like bonds, loans from financial institutions, and other borrowings with repayment schedules extending beyond 12 months. © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Characteristics of Long-Term Debt Maturity Period: It typically has a repayment schedule that extends beyond one year, often ranging from a few years to several decades. Interest Payments: Companies are generally required to make periodic interest payments on long-term debt, which may be fixed or variable, depending on the terms of the debt. Collateral: Some long-term debts, like mortgages or secured bonds, are backed by collateral, meaning specific assets are pledged as security. © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Risks associated with long term debts Financial Risk: Excessive long-term debt can increase financial risk by burdening the company with fixed interest and principal repayments, especially if revenues or profits decline. Solvency Issues: High levels of long-term debt relative to equity or earnings can threaten a company’s solvency, making it harder to meet financial obligations, particularly in times of economic downturn. © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.  Examples of key ratios © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Times Interest Earned Indicates long-term debt-paying ability Consider only recurring income – Exclude discontinued operations – Exclude extraordinary items Include interest capitalized © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Times Interest Earned— Continued © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Times Interest Earned— Continued Comparisons – 3 to 5 years of historical data Lowest value is the primary indicator of interest coverage – Industry competitors and averages Secondary analysis – Interest coverage on long-term debt – Use only interest expense on long-term debt © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Fixed Charge Coverage Indicates a firm’s ability to cover fixed charges Fixed charges include – Interest portion of operating lease payments General approximation is to include 1/3 of payments © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Debt Ratio Indicates the firm’s long-term debt-paying ability Total liabilities – Includes short-term liabilities, reserves, deferred tax liability, noncontrolling interests, redeemable preferred stock, and any other non current liability Indicates the percentage of assets financed by creditors Total Liabilities Debt Ratio = Total Assets © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Debt Ratio—Continued Comparisons – Competitors and industry averages Variations in application – Short-term liabilities Exclude as they are not part of long-term source of funds Include as they become part of the total source of funds – Liabilities that do not necessarily represent a commitment to pay out funds in the future © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Debt Ratio and Certain Liabilities Reserves – Matches an expense but do not represent definite commitments to pay out funds in the future – Infrequently used in U.S. GAAP statements © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Debt Ratio and Certain Liabilities— Continued Deferred Income Taxes – Difference between income tax expense and income taxes payable – Recognized as a liability by GAAP; include in ratio © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Debt Ratio and Certain Liabilities— Continued Noncontrolling Interest – Proportion of a consolidated entity that is not owned by the controlling parent company – Appears on the balance sheet as part of stockholders’ equity – Some firms exclude from ratio as it does not represent a commitment to pay funds to outsiders – Included in ratio for conservative application © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Debt Ratio and Certain Liabilities— Continued Redeemable Preferred Stock – Not disclosed under stockholders’ equity – Exclude from ratio; does not present a normal debt relationship – Included in ratio for conservative application © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Debt/Equity Ratio Determines the entity’s long-term debt-paying ability Helps determine how well creditors are protected in case of insolvency Comparisons – Competitors and industry averages Total Liabilities Debt/Equity Ratio = Shareholders' Equity © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Debt to Tangible Net Worth Ratio Determines the entity’s long-term debt payment ability Indicates how well creditors are protected in case of the firm’s insolvency More conservative than debt ratio or debt/equity ratio due to exclusion of intangibles Total Liabilitites Debt to Tangible Net Worth Ratio = Shareholders' Equity  Intangible Assets © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.  Example: If a company has: -Total Debt of $1 million - Total Equity of $2 million - Intangible Assets of $500,000 Then the Tangible Net Worth would be: Tangible Net Worth=$2,000,000−$500,000=$1,500,000 So the debt to Tangible Net Worth Ratio would be: This means the company has $0.67 of debt for every dollar of tangible net worth A low ratio indicates that the company has a …… equity base relative to its debt, suggesting …… financial health. © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Other Long-Term Debt-Paying Ability Ratios Current debt/net worth ratio – Indicates a relationship between current liabilities and funds contributed by shareholders – The higher the proportion of funds provided by current liabilities, the greater the risk Total capitalization ratio – Compares long-term debt to total capitalization – Total capitalization consist of long-term debt, preferred stock, and common stockholders’ equity – The lower the ratio, the lower the risk © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Other Long-Term Debt-Paying Ability Ratios—Continued Fixed asset/equity ratio – The extent to which shareholders have provided funds in relation to fixed assets Example: Let’s say a company has the following financial data: Fixed Assets (Net of Depreciation): $1,200,000 Shareholders’ Equity: $2,000,000 The Fixed Asset to Equity Ratio = $1,200,000 / $2,000,000=0.6 ====A ratio of 0.6 means that for every dollar of equity, $0.60 is invested in fixed assets. A …….. ratio indicates that less equity is tied up in long-term, non-liquid assets, which could be a sign of greater financial flexibility A …… ratio suggests that a large portion of the company's equity is invested in fixed assets, which could imply less flexibility and potential difficulties in generating liquidity from these assets. © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Long-Term Assets versus Long-Term Debt Consider the assets of the firm when determining the long-term debt-paying ability Ability for analysis is limited – Financial statements do not disclose market or liquidation value – Certain assets may have market value significantly greater then carrying value Certain assets may have earnings potential in the future © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Long-Term Leasing Capital leases – Asset and liability are reported on the balance sheet Operating leases – Reported as expense on the income statement – Supplemental analysis using future payments One-third can be estimated as interest Two-thirds can be added to the fixed assets and long-term liabilities for debt ratio analyses © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.