3.9 Debt Ratios and Decomposing Financial Leverage and Solvency

It is an open question whether the financing decision adds value to shareholders or not.  We will make two observations here.  First, we have already seen that increasing financial leverage has a positive impact upon ROE.  This follows from the DuPont analysis where ROE was the product of ROA and Financial Leverage.  However, it also increases risk and so equity investors will require a higher rate of return.  If this higher rate of return exactly offsets the positive impact from financial leverage then it is all awash and the financing decision has no impact upon shareholder value.  If the financing decision interacts with the investment decision, for example as per a financial institution then the financing decision matters.  As a result, when analyzing the financing decision analysts are interested in assessing the risk of the firm and ultimately how this risk translates into changes in the cost of equity capital.  We consider this issue formally in the Valuation part of this book.  But first, we will analyze the financing decision and then relate it to growth forecasts for net income.

Solvency versus Liquidity

If a firm’s financial leverage becomes too high then questions arise regarding whether or not a firm is likely to be a going concern.  Firms go bankrupt because they lack the cash (and or access to cash) to repay debt.  Liquidity analysis adopts a short run focus and liquidity ratios are designed to assess a firm’s ability to meet their short term obligations.  Solvency on the other hand adopts a longer term focus and Debt Ratios attempt to assess a company’s ability to meet its long term obligations and thus whether it is a going concern. 

Recall from the DuPont decomposition that the Financial Leverage term is Assets/Shareholders Equity.  Shareholders equity is defined from the basic accounting identity as: 

Dividing through by shareholders Equity and rearranging then the Financial Leverage term can be re-expressed as:

The last term is more commonly expressed relative to Total Assets as the Debt Ratio:

There are a number of variations to the Debt Ratio and the ones covered by the Valuation Tutor calculator are listed and defined below:

In addition, when interest expense is focused upon this also defines a coverage ratio:

Tutor Reconciliation:  Proctor and Gamble (PG)

Our objective is to reconcile the following from the 10-K:

Step 1:  Bring up the Income Statement and Balance Sheet for Proctor and Gamble as described in section 3.2 as displayed above. 

For Proctor and Gamble you will see that Debt Due within one year = $8,472 and the “Long Term Debt” ($21,360).

Step 2:  Click on Calculate and we can verify the input and derived fields for the following: