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CHAPTER7CREDIT ANALYSIS CAPITAL STRUCTURE AND SOLVENCYPrepared by : Sukjit Singh815739 Ayushafiza Zulkifly816248Parimala Devi Ponnan819260Asiah Abd. Harith816444

Prepared for:Dr. Norshafizah Hanafi

BWFF 5033 FINANCIAL REPORTING AND STATEMENT ANALYSIS

Capital Structure and Solvency AnalysisBASIC OF SOLVENCYCapital StructureMotivation for DebtFinancial LeverageCAPITAL STRUCTURE COMPOSITION AND SOLVENCYCommon size statementCapital Structure MeasuresInterpretation of MeasuresAsset-Based Solvency MeasuresEARNINGS COVERAGEIntroduction to Earning CoverageBASIC SOLVENCYPROFITABILITYLIQUIDITYSOLVENCYDEVELOPMENTBASIC SOLVENCYSolvency - refers to a companys long-run financial viability and its ability to cover long-term obligationsCapital structure - financing sources and their attributesEarning power - recurring ability to generate cash from operationsLoan covenants - protection against insolvency and financial distress; they define conditions of default at a level to allow the opportunity to collect on a loan before severe distress

BASIC SOLVENCYCAPITAL STRUCTUREEquity financing Risk capital of a company Uncertain and unspecified return Lack of any repayment pattern Contributes to a companys stability and solvencyDebt financing Must be repaid with interest Specified repayment patternWhen the proportion of debt financing is higher, the higher are the resulting fixed charges and repayment commitments

BASIC SOLVENCYMOTIVATION DEBTFrom a shareholders perspective, debt financing is less expensive than equity financing because:1.Financial Leverage--Interest on most debt is fixed, and provided interest is less than the return earned from debt financing, the excess return goes to equity investors.2.Tax Deductibility of Interest--Interest is a tax-deductible expense whereas dividends are not.

BASIC SOLVENCYFINANCIAL LEVERAGEFinancial Leverage RatioTotal assetsCommon equity capitalGreater the proportion of financing from equity vs. debt lower the financial leverage ratio

Note: Financial leverage ratio is a component of the disaggregated return on equity:ROCE = Adjusted profit margin Asset turnover Leverage

Capital Structure Composition And SolvencySeveral measures - used to estimate degree of financial leverage

Evaluate the risk of insolvencyCapital Structure Composition and Solvency

Capital structure composition analysisPerformed by constructing a common-size statement of liabilities and equityReveals relative magnitude of financing sourcesAllows direct comparisons across different companiesTwo Variations(1) Use ratios, and (2) Long-term financing sources- Exclude current liabilitiesCommon-Size Statements in Solvency AnalysisCapital Structure Composition and Solvency

Common-Size Statements in Solvency Analysis

11Capital Structure Composition and Solvency Total Debt to Total Capital Ratio

Comprehensive measure of the relation between total debt and total capital Also called Total debt ratio

Capital Structure Composition and Solvency Total Debt to Total Capital Ratio Total Debt_ Total capital

Exp : Campbell soup (Year 11)

$1,278+772.6+305.0 $1793.4+2355.6

= 0.57

Debt constituting 57% of Campbell Soups capital structureCapital Structure Composition and Solvency Total Debt to Equity Capital

Total Debt_____ Shareholders equity

$ 2,355.6_ $ 1,793.4

= 1.31

Credit financing equals 1.31 for every $1 of equity financingCapital Structure Composition and Solvency Long-Term Debt to Equity Capital

Measures the relation of LT debt to equity capital.Commonly referred to as the debt to equity ratio.

Capital Structure Composition and Solvency Long Term Debt To Equity Capital

Long-term Debt__ Shareholders equity

$2,355.6-1,278_ $1,793.4

=0.60

A ratio in excess of 1.1 indicates greater long-term debt financing compared too equity capital.Capital Structure Composition and Solvency Short-Term Debt to Total Debt

Indicator of enterprise reliance on short-term financing. Usually subject to frequent changes in interest rates.

Capital Structure Composition and Solvency Common-size and ratio analyses of capital structure mainly reflect capital structure riskCapital structure measures serve as screening devicesExtended analysis focuses financial condition, results of operations, and future prospectsPrior to long-term solvency analysis, we perform liquidity analysis to be satisfied about near-term survivalAdditional analyses include examination ofDebt maturities (amount and timing)Interest costsRisk-bearing factors (earnings persistence, industry performance, and asset composition)Interpretation of Capital Structure Measures18Capital Structure Composition and Solvency Asset composition in solvency analysisImportant tool in assessing capital structure risk exposure.Typically evaluated using common-size statements of asset balances.

Asset-Based Measures of Solvency

19Capital Structure Composition and Solvency Asset composition in solvency analysisImportant tool in assessing capital structure risk exposure.Typically evaluated using common-size statements of asset balances.

Asset-Based Measures of Solvency

20Capital Structure Composition and Solvency Capital structure composition analysisPerformed by constructing a common-size statement of liabilities and equityReveals relative magnitude of financing sourcesAllows direct comparisons across different companiesTwo Variations(1) Use ratios, and (2) Long-term financing sources- Exclude current liabilities

Common-Size Statements in Solvency Analysis21Capital Structure Composition and Solvency Common-Size Statements in Solvency Analysis

22Capital Structure Composition and Solvency Total Debt to Total Capital Ratio

Comprehensive measure of the relation between total debt and total capital Also called Total debt ratio

23Capital Structure Composition and Solvency Total Debt to Total Capital Ratio

Comprehensive measure of the relation between total debt and total capital Also called Total debt ratio

24Capital Structure Composition and Solvency Total Debt to Total Capital Ratio Total Debt_ Total capital

Exp : Campbell soup (Year 11)

$1,278+772.6+305.0 $1793.4+2355.6

= 0.57

Debt constituting 57% of Campbell Soups capital structure

25Capital Structure Composition and Solvency Total Debt to Equity Capital

Total Debt_____ Shareholders equity

$ 2,355.6_ $ 1,793.4

= 1.31

Credit financing equals 1.31 for every $1 of equity financing

26Capital Structure Composition and Solvency Long-Term Debt to Equity Capital

Measures the relation of LT debt to equity capital.Commonly referred to as the debt to equity ratio.

27Capital Structure Composition and Solvency Long Term Debt To Equity Capital

Long-term Debt__ Shareholders equity

$2,355.6-1,278_ $1,793.4

=0.60

A ratio in excess of 1.1 indicates greater long-term debt financing compared too equity capital.

28Capital Structure Composition and Solvency Short-Term Debt to Total Debt

Indicator of enterprise reliance on short-term financing. Usually subject to frequent changes in interest rates.29Capital Structure Composition and Solvency Common-size and ratio analyses of capital structure mainly reflect capital structure riskCapital structure measures serve as screening devicesExtended analysis focuses financial condition, results of operations, and future prospectsPrior to long-term solvency analysis, we perform liquidity analysis to be satisfied about near-term survivalAdditional analyses include examination ofDebt maturities (amount and timing)Interest costsRisk-bearing factors (earnings persistence, industry performance, and asset composition)Interpretation of Capital Structure Measures30Capital Structure Composition and Solvency Asset composition in solvency analysisImportant tool in assessing capital structure risk exposure.Typically evaluated using common-size statements of asset balances.Asset-Based Measures of Solvency

31Earnings CoverageEarning coverage measures focus on the relation between debt-related fixed charges and companys earning available to meet this charges.Earning to fixed charges

Earnings to fixed charges

32Earnings CoverageTimes Interest Earned ratio

Times Interest Earned

33Earnings Coverage1)Earnings-coverage measures provide insight into the ability of a company to meet its fixed charges2)High correlation between earnings-coverage measures and default rate on debt3)Earnings variability and persistence is important4)Use earnings before discontinued operations, extraordinary items, and cumulative effects of accounting changes for single year analysis-but include them in computing the average ratio over several years

Interpreting Earnings Coverage34Earnings CoverageA company can increase risks (and potential returns) of equity holders by increasing leverageSubstitution of debt for equity yields a riskier capital structureRelation between risk and return in a capital structure existsOnly personal analysis can reflect ones unique risk and return expectationsCapital Structure Risk & Return35THANK YOUSheet1Tennessee Teletechs Capital StructureIllustrationCommon-Size AnalysisLack of liquidity can limit:Severe illiquidity often precedes:ExamplesTechnology Resources, Inc., experiences a doubling of current assets and a quadrupling of currentSelected information from Technology Resources for the end of Year 1:Current liabilities$ 428,00019%Advantages of discountsLower profitabilityCashliabilities with no change in its working capital. This yielded a prosperity squeeze evidenced by aSales for Year 1$360,000Texas Electrics current assets along with their common-size percentagesLong-term debt500,00022.2Profitable opportunitiesRestricted opportunitiesCash equivalents50% decline in the current ratio.Receivables40,000are reproduced below for Years 1 and 2:Equity capitalManagement actionsLoss of owner controlMarketable securitiesInventories*50,000Cash$ 30,00030%$ 20,00020%Preferred stock400,00017.8Coverage of current obligationsLoss of capital investmentAccounts receivableYear 1Year 2Accounts payable20,000Accounts receivable40,0004030,00030Common stock800,00035.6Insolvency and bankruptcyInventoriesCurrent assets$300,000$600,000Cost of goods sold (including depreciation of $30,000)320,000Inventories30,0003050,00050%Paid-in capital20,0000.9Prepaid expensesCurrent liabilities(100,000)(400,000)Total current assets$100,000100%$100,000100Retained earnings102,0004.5Working capital$200,000$200,000*Beginning inventory is $100,000.Total equity capital1,322,00058.8ExamplesCurrent ratio3:11.5:1These relate to purchases included in cost of goods sold.An analysis of Texas Electrics common-size percentages reveals a markedTotal liabilities and equity$2,250,000100%Accounts payabledeterioration in current asset liquidity in Year 2 relative to Year 1. This isNotes payableWe estimate Technology Resources purchases per day as:evidenced by a 10% decline for both cash and accounts receivable.ST bank loansEnding inventory$ 50,000Taxes payableTechnology Resources, Inc., increases its current ratio by making an earlier-than-normal payoff ofCost of goods sold320,000Accrued expenses$50,000 of current liabilities:370,000Before PayoffAfter PayoffLess: Beginning inventory(100,000)Current assets$200,000$150,000Cost of goods purchased and manufactured270,000Current liabilities(100,000)(50,000)Less: Depreciation in cost of goods sold(30,000)Working capital$100,000$100,000Purchases$240,000Current ratio2:13:1Purchases per day = $240,000/360 = $666.67Then, the net trade cycle is computed as:Accounts receivable

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Sheet1Tennessee Teletechs Capital StructureIllustrationCommon-Size AnalysisLack of liquidity can limit:Severe illiquidity often precedes:ExamplesTechnology Resources, Inc., experiences a doubling of current assets and a quadrupling of currentSelected information from Technology Resources for the end of Year 1:Current liabilities$ 428,00019%Advantages of discountsLower profitabilityCashliabilities with no change in its working capital. This yielded a prosperity squeeze evidenced by aSales for Year 1$360,000Texas Electrics current assets along with their common-size percentagesLong-term debt500,00022.2Profitable opportunitiesRestricted opportunitiesCash equivalents50% decline in the current ratio.Receivables40,000are reproduced below for Years 1 and 2:Equity capitalManagement actionsLoss of owner controlMarketable securitiesInventories*50,000Cash$ 30,00030%$ 20,00020%Preferred stock400,00017.8Coverage of current obligationsLoss of capital investmentAccounts receivableYear 1Year 2Accounts payable20,000Accounts receivable40,0004030,00030Common stock800,00035.6Insolvency and bankruptcyInventoriesCurrent assets$300,000$600,000Cost of goods sold (including depreciation of $30,000)320,000Inventories30,0003050,00050%Paid-in capital20,0000.9Prepaid expensesCurrent liabilities(100,000)(400,000)Total current assets$100,000100%$100,000100Retained earnings102,0004.5Working capital$200,000$200,000*Beginning inventory is $100,000.Total equity capital1,322,00058.8ExamplesCurrent ratio3:11.5:1These relate to purchases included in cost of goods sold.An analysis of Texas Electrics common-size percentages reveals a markedTotal liabilities and equity$2,250,000100%Accounts payabledeterioration in current asset liquidity in Year 2 relative to Year 1. This isNotes payableWe estimate Technology Resources purchases per day as:evidenced by a 10% decline for both cash and accounts receivable.ST bank loansEnding inventory$ 50,000Taxes payableTechnology Resources, Inc., increases its current ratio by making an earlier-than-normal payoff ofCost of goods sold320,000Accrued expenses$50,000 of current liabilities:370,000Before PayoffAfter PayoffLess: Beginning inventory(100,000)Current assets$200,000$150,000Cost of goods purchased and manufactured270,000Current liabilities(100,000)(50,000)Less: Depreciation in cost of goods sold(30,000)Working capital$100,000$100,000Purchases$240,000Current ratio2:13:1Purchases per day = $240,000/360 = $666.67Then, the net trade cycle is computed as:Accounts receivable

Sheet2

Sheet3

Sheet1Target Corporation Income Statements

in millions200520042003Sales46,83942,02537,410COGS31,44528,38925,498GP15,39413,63611,912Selling, G&A exp10,5349,3798,134Depn & amort exp1,2591,098967Int exp570556584Income before tax3,0312,6032,227Income tax exp1,146984851Income/loss from extraordinary items1,313190247& discontinued operationsNet income3,1981,8091,623Outstanding shares891912910

Selected ratios in %Sales growth11.46%12.34%GP margin32.86632.447Selling, G&A exp/sales22.4922.318Depn exp/gross prior year PP&E6.3335.245Int exp/orior year long term debt7.1734.982Income tax exp/pretax income37.80937.803

Sheet2Target Corporation Balance Sheet(in million)CashReceivablesInventoriesOther curent assets Total current assetsPP&EAcc depnNet PP & EOther assetsAPCurrent portion of long-term debtAccrued expIncome taxes & other

Sheet3Capital structure and solvency anlaysis

Basics of SolvencyCapital composition And SolvencyCapital structureCommon-size statementMotivation for debtCapital structure measuresFinancial leverageInterpretation of measuresAsset-based Solvency measuresIntroduction to earning coverageEarning to fixed charges ratioEarnings available for fixed chargesFixed charges

Sheet1Target Corporation Income Statements

in millions200520042003Sales46,83942,02537,410COGS31,44528,38925,498GP15,39413,63611,912Selling, G&A exp10,5349,3798,134Depn & amort exp1,2591,098967Int exp570556584Income before tax3,0312,6032,227Income tax exp1,146984851Income/loss from extraordinary items1,313190247& discontinued operationsNet income3,1981,8091,623Outstanding shares891912910

Selected ratios in %Sales growth11.46%12.34%GP margin32.86632.447Selling, G&A exp/sales22.4922.318Depn exp/gross prior year PP&E6.3335.245Int exp/orior year long term debt7.1734.982Income tax exp/pretax income37.80937.803

Sheet2Target Corporation Balance Sheet(in million)CashReceivablesInventoriesOther curent assets Total current assetsPP&EAcc depnNet PP & EOther assetsAPCurrent portion of long-term debtAccrued expIncome taxes & other

Sheet3Capital structure and solvency anlaysis

Basics of SolvencyCapital composition And SolvencyCapital structureCommon-size statementMotivation for debtCapital structure measuresFinancial leverageInterpretation of measuresAsset-based Solvency measuresIntroduction to earning coverageEarning to fixed charges ratioIncome+Tax expense+Interest expenseInterest expense