Capital Structure & Long-Term Solvency
Category: Financial Control Management
There are a number of key elements involved in the evaluation of the long-term solvency of an enterprise. The analysis of capital structure is concerned with the types of capital funds used to finance the enterprise, ranging from «patient» and permanent equity capital to short-term funds that are a temporary, and, consequently, a much more risky source.
Because the owners’ equity of an enterprise is measured by the excess of total assets over total liabilities, and analytical revision of asset book values will also result in a change in amount of the owners’ equity. The type of assets an enterprise employs in its operations should determine to some extent the sources of funds used to finance them:
It is customarily held that fixed and other long-term assets should not be financed by means of short-term loans;
The Working Capital and particularly seasonal working capital needs, can be appropriately financed by mean of short-term credits;
The typical source of Working Capital financing should be the Permanent Resources (Owners’ Equity + Long-Term Liabilities);
The value Long-Term Assets is compared to the one of Owners’ Equity and Permanent Resources;
Judging only by the distribution of assets and the related capital structure, it would appear that since a relatively high proportion of assets is current (61%), a 41 percent debt and current liabilities position is not excessive.
In addition to serving as an inflation hedge, a primary reason for the employment of debt by an enterprise is that up to a certain point, debt is, from the point of view of the ownership, a less expensive source of funds that equity capital. This is so for two main reasons:
The interest cost of debt is fixed, and thus, as long as it is lower that the return that can be earned on the funds supplied b creditors, this excess return accrues to the benefit of the equity;
Unlike dividends, which are considered a distribution of profits, interest is considered an expense and is, consequently, tax deductible.
Financial Leverage
The Financial Leverage means the inclusion in the capital structure of an enterprise of debt that pays a fixed return. Since no creditor or lender would be willing to put up loan funds without the cushion and safety provided by the owners’ equity capital, this borrowing process is also referred to as «trading on the equity», that is, utilizing the existence of a given amount of equity capital as a borrowing base. In other words, the Financial Leverage measures the relationship between total assets and the common equity capital that finances them.
The formula of Financial Leverage:
The Financial Leverage Ratio indicates that every Leu of common equity commands X Leu in assets of company.
The effect of leverage on operating results is positive when the return on the equity capital exceeds the return on total assets. The effect of Financial Leverage can be measured by the following formula:
Neutral or Negative effect of Financial Leverage is best described by the Financial Leverage Index, as presented in the above formula and it is so when the ROE is equal or lower than ROA.
The Capital Structure
A simple measure of financial risk in an enterprise is the composition of its Capital Structure. This can be done best by constructing a common-size statement of the liabilities and equity section of the balance sheet.
Additionally, the structural changes and trends for the last years are to be analyzed. These results are compared to the average industry and competitors’ indicators in conjunction with the capital structure ratios. A variation of the approach of analyzing capital structure by means of common-size or component percentages is to analyze it by means of ratios.
Total Debt to Total Capital:
Measures the share of assets that are financed by debt or the share of debt in the capital of the company;
The higher the proportion of debt, the larger the fixed charges of interest and debt repayment, the greater the likelihood of insolvency during protracted periods of earnings decline or other adversities.
Total Debt to Equity Capital measures the relationship of debt to equity capital only.
Long-Term Debt to Equity Capital measures the relationship of long-term debt to equity capital. A ratio in excess of 1: 1 indicates a higher long-term debt participation as compared to equity capital.
The Long-Term Solvency
An important limitation of the measurements of debt to equity relationships is that they do not focus on the availability of cash flows that are necessary to service the enterprise’s debt. In fact, as a debt obligation is repaid, the debt to equity ratio tends to improve whereas the yearly amount of cash needed to pay interest and sinking fund requirements may remain the same or may even increase.
While a highly profitable enterprise can in the short run be illiquid because of the composition of its assets, earning power is in the long run the major source of liquidity and of borrowing power. Earnings-coverage ratios measure directly the relationship between debt-related fixed charges and the earnings available to meet these charges.
Fixed-debt charges are paid out of cash rather than out of net income. The analyst must realize that an unadjusted net income figure may not be a correct measure of cash available to meet fixed charges.
Cash Flow Coverage Ratio is calculated based on the following formula:
