3.5 Debt Ratios

LG 4 3.5 Debt Ratios

The debt position of a firm indicates the amount of other people’s money being used to generate profits. In general, the financial analyst is most concerned with long-term debts because these commit the firm to a stream of contractual pay- ments over the long run. The more debt a firm has, the greater its risk of being unable to meet its contractual debt payments. Because creditors’ claims must be satisfied before the earnings can be distributed to shareholders, current and prospective shareholders pay close attention to the firm’s ability to repay debts. Lenders are also concerned about the firm’s indebtedness.

financial leverage The magnification of risk and

In general, the more debt a firm uses in relation to its total assets, the greater return through the use of fixed- its financial leverage. Financial leverage is the magnification of risk and return

cost financing, such as debt

through the use of fixed-cost financing, such as debt and preferred stock. The

and preferred stock.

more fixed-cost debt a firm uses, the greater will be its expected risk and return.

Example 3.5 3 Patty Akers is in the process of incorporating her new business. After much analysis she determined that an initial investment of $50,000—$20,000 in current

assets and $30,000 in fixed assets—is necessary. These funds can be obtained in either of two ways. The first is the no-debt plan, under which she would invest the full $50,000 without borrowing. The other alternative, the debt plan, involves investing $25,000 and borrowing the balance of $25,000 at 12% annual interest.

Patty expects $30,000 in sales, $18,000 in operating expenses, and a 40% tax rate. Projected balance sheets and income statements associated with the two plans are summarized in Table 3.6. The no-debt plan results in after-tax profits of $7,200, which represent a 14.4% rate of return on Patty’s $50,000 investment. The debt plan results in $5,400 of after-tax profits, which represent a 21.6% rate of return on Patty’s investment of $25,000. The debt plan provides Patty with a higher rate of return, but the risk of this plan is also greater, because the annual $3,000 of interest must be paid whether Patty’s business is profitable or not.

The example demonstrates that with increased debt comes greater risk as well as higher potential return. Therefore, the greater the financial leverage, the greater the potential risk and return. A detailed discussion of the impact of debt

degree of indebtedness Measures the amount of debt

on the firm’s risk, return, and value is included in Chapter 12. Here, we empha-

relative to other significant

size the use of financial debt ratios to assess externally a firm’s debt position.

balance sheet amounts.

There are two general types of debt measures: measures of the degree of indebtedness and measures of the ability to service debts. The degree of indebted-

ability to service debts The ability of a firm to make

ness measures the amount of debt relative to other significant balance sheet

the payments required on a

amounts. A popular measure of the degree of indebtedness is the debt ratio.

scheduled basis over the life of

The second type of debt measure, the ability to service debts, reflects a firm’s

CHAPTER 3

Financial Statements and Ratio Analysis

TA B L E 3 . 6 Financial Statements Associated with Patty’s Alternatives

Balance Sheets

No-debt plan

Debt plan

Current assets

Fixed assets

Total assets

Debt (12% interest)

Total liabilities and equity

Income Statements

Less: Operating expenses

Operating profits

Less: Interest expense

Net profits before taxes

Less: Taxes (rate = 40%)

(2) Net profits after taxes

Return on equity 3(2) , (1)4

The term to service debts simply means to pay debts on time. The firm’s ability coverage ratios

to pay certain fixed charges is measured using coverage ratios. Typically, higher

Ratios that measure the firm’s

coverage ratios are preferred (especially by the firm’s lenders), but a very high

ability to pay certain fixed

ratio might indicate that the firm’s management is too conservative and might be

charges.

able to earn higher returns by borrowing more. In general, the lower the firm’s coverage ratios, the less certain it is to be able to pay fixed obligations. If a firm is unable to pay these obligations, its creditors may seek immediate repayment, which in most instances would force a firm into bankruptcy. Two popular coverage ratios are the times interest earned ratio and the fixed-payment cov- erage ratio.