4.16 Analyzing Financial Leverage

It is an open question whether the financing decision adds value to shareholders or not.  We will make two observations here.  First, we will see that increasing financial leverage has a positive impact upon ROE.  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. 

We now examine how both Wal-Mart and Target have approached the financing decision.

Example:  Wal-Mart versus Target

As a first pass the DuPont analysis and the Debt Ratio reinforce the conclusion that Target is carrying more leverage than Wal-Mart although Target appears to be currently reducing its leverage to bring it more in line with Wal-Mart’s.

However, to focus more sharply upon the firm’s financing decision the Debt ratio is further refined into the Debt to Equity Ratio which traditionally is expressed as:

Debt to Equity Ratio = (Long-Term Debt + Value of Leases)/Shareholders Equity

 

Long Term Debt to Equity Ratio = Long-Term Debt/Shareholders Equity

However, in today’s world traditional financing approaches have changed significantly with the use of derivatives and in particular interest rate swaps.  As a result, much financing is done short term and then swapped into desirable long term patterns using interest rate swaps that can extend out to 30-years.  This implies that the Debt to Equity and the Long Term Debt Ratios be redefined to include short term debt.

Debt to Equity Ratio = (Total Debt + Value of Leases)/Shareholders Equity

Term Debt to Equity Ratio = Debt Issued / Shareholders Equity

The above ratios provide insight into the extent of debt leverage for the firm and immediately raise questions regarding the amount of interest coverage the firm has.  The first ratio is relevant to a traditionally financed firm that matches long term investment with long term financing and the second ratio is relevant to a modern firm that exploits derivatives and swaps to manage its financing decision.

Both firms exhibit a business model built around ownership as opposed to leasing.  This is reinforced from the following excerpts from their respective 10-K’s:

Wal-Mart 2010 10-K

ITEM 2. PROPERTIES 

 

The number of discount stores, supercenters, Neighborhood Markets and Sam’s Clubs located in each state in the United States and the number of units located in each of the countries in which we operate are disclosed as of fiscal year-end January 31, 2010 in our Annual Report to Shareholders under the caption “Fiscal 2010 End-of-Year Store Count” and are incorporated herein by reference. Portions of such Annual Report to Shareholders are included as an exhibit to this Annual Report on Form 10-K.

United States.  As of January 31, 2010, in the United States, we owned 3,214 of the buildings in which discount stores, supercenters and Neighborhood Markets operated and 483 of the buildings in which our Sam’s Clubs operated. Land on which our stores are located is either owned or leased by the company. In the United States, we lease the remaining buildings in which our stores and clubs operate from either commercial property developers pursuant to capital or operating lease arrangements or from local governmental entities in connection with industrial revenue bond financing arrangements. All store leases provide for annual rentals, some of which escalate during the original lease term. In some cases, the leases provide for additional rent based on sales volume. Substantially all of the company’s store and club leases have renewal options, some of which include escalation clauses causing an increase in rents.

International.  We operate our International segment stores and restaurants in a combination of owned and leased properties in each country in which our International segment operates. As of the end of fiscal 2010, we owned 33 properties in Argentina, 161 properties in Brazil, 117 properties in Canada, 125 properties in Chile, 1 property in China, 69 properties in Costa Rica, 9 properties in El Salvador, 14 properties in Guatemala, 7 properties in Honduras, 52 properties in Japan, 530 properties in Mexico, 25 properties in Nicaragua, 11 properties in Puerto Rico and 239 properties in the United Kingdom. The remaining operating units in each such country are leased on terms that vary from property to property. We utilize both owned and leased properties for office facilities in each country in which we are conducting business. As of the end of fiscal 2010, our International operations are supported by 132 distribution facilities. Of these 132 distribution facilities, we owned and operated 34 and leased and operated 37. Third parties owned and operated the remaining 61 distribution facilities.

 

Target 2010 10-K

 

The following table summarizes the number of owned or leased stores and distribution centers at January 30, 2010:

 (a)  Properties within the "combined" category are primarily owned buildings on leased land.

(b)  The 38 distribution centers have a total of 48,588 thousand square feet.

As a result, for the debt ratios we will compute relative to Debt and ignore leases.  The degree of Financial Leverage in terms of Net Income as follows:

Degree of Financial Leverage = EBIT/EBT

Wal-Mart 2009

Operating Income  = $24,002

Earnings Before Tax = $22,118

Degree of Financial Leverage = 1.085

 

Target  2009

Operating Income  = $4,673

Earnings Before Tax = $3872

Degree of Financial Leverage = 1.207

The above is revealing of differences in the two firm’s financing strategies whereby Target has a higher degree of financial leverage than does Wal-Mart.