© 2000 John Petroff
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© 2000 John Petroff |
4)- Assessment of risk
How dangerous is it for a firm to take on debt? The greatest danger is, of course, the potential for bankruptcy, and it is the most difficult to assess. The next two sections present different approaches to comprehensive assessment of bankruptcy potential. Here we start with partial and more selective indicators. Volatility is relatively easy to measure, but difficult to interpret. The potential for default is not as easily measured but it is more reliable, and it is usually determined with the help of coverage ratios.
a)- Profit volatility
A company stock BETA statistics is a measure of volatility. But it measures the volatility of the stock market price which is clearly affected by many stock market trends and attitudes. Thus, BETA does not measure financial risk. Moreover BETA statistics are notoriously unstable. Yet, the stock market volatility is a reflection of investor's perceived company risk. Such company risk is mostly commercial risk, but forms of risk amplify it. Operating, financial, accounting and other forms of risk were discussed in Chapter 2. To the extent that financial decisions can be linked to recent changes in BETA, looking at changes in BETA can be indicative.
Measuring net after tax profit volatility with, for instance, a standard deviation, is closer to the consequences of financial leverage, but, it too fails to isolate financial risk. Moreover, to calculate this standard deviation, several years of company results are necessary, and these results may not reflect current strategies. Yet, because profit instability will affect cost of capital and capital structure decisions, it must be one of the statistics used by an analyst. To avoid bringing in distortions from extraordinary items, one can choose operating profits or even earnings before interest and taxes (EBIT) instead.
b)- Coverage ratios as measures of default potential
Coverage ratios are intended to reveal the ability of a firm to pay its fixed charges by measuring how many times operating earnings (EBIT) cover expenses. There are several versions of coverage ratios depending on what expenses are included. The first and most relevant version is the interest coverage ratio, also known as times interest earned (TIE)
TIE = EBIT / Interest expense
For instance, the interest coverage ratio for Company X in 1996 with 66% debt was
TIE = $3,500 / 1,280 = 2,73
Table T-11.1 shows that the value of TIE for Company X declines from 9.11 with 20% debt to 2.23 with 80% debt. Obviously, the ratio deteriorates completely when sales slump as can be verified in Tables Table T-11.2, Table T-11.3 and Table T-11.4. A coverage ratio of less than one indicate losses. One should keep in mind that the interest expense included in the interest coverage ratio must not be net interest (i.e. interest income is usually deducted from interest expense in the income statement). The reason for this is that the ratio is intended to help in predicting company's ability to pay its interest expense in the future, and interest income may not be present then.
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To illustrate the use of times interest earned, we return to the example of J.C. Penney. From Table T-6.9 - J.C. Penney Company Inc. - Income Statement, we take the amounts of interest expense of $ 480 millions and earnings before interest and taxes of $ 1,435 millions in 1998. This give a times interest earned of TIE = $ 1,435 / 480 = 2.99 which can be found in Table T-5.20, J.C. Penney Company Inc. - Ratios. Table T-5.20 also shows that times interest earned in 1997 was slightly lower at 2.69. Comparing J.C. Penney to the department store industry reveals that, J.C. Penney's times interest earned is just slightly below the median values of 3.3 in 1999 and 2.8 in 1998. This reinforces the previous conclusion that even though J.C. Penney has a higher financial leverage than most of its competitors, such financing does not constitute a major financial risk. |
Lease payments can be very significant for certain industries (such as airlines). Financial leases (i.e. capital leases) are automatically recorded in the balance sheet, and the portion of the payment representing interest is included in interest expense. But operating leases are not shown on the balance sheet, and the implicit interest expense is not separated out from the annual lease payment. An analyst should estimate this implied fixed interest portion of such rentals (as required by the SEC in the United States) and add it in with interest expense. A rule of thumb for estimating such implicit interest that used to be recommended in finance textbooks, was to take one third of lease payments. A more accurate method would be to capitalize the lease payments (i.e. take the present value of the life of the lease), and apply a long term interest rate to that total.
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Let us take Delta Air Lines to demonstrate how interest coverage is modified if operating lease implied interest is included. First we calculate times interest earned without operating lease implied interest. From Table T-6.11 - Delta Air Lines - Income Statement, we take the amounts for operating income of $ 1,870 millions and interest expense of $ 199 millions in 1999. This give a times interest earned of TIE = 1,870 / 199 = 9.4 which can be found in Table T-5.21 - Delta Air Lines - Ratios. Compared to the industry which has a times interest earned ratio of 3.9, Delta interest coverage is much better. Now let us calculated the implied interest in operating leases. From note 6 to 1999 financial statements we take the amounts of minimum rental commitment under operating leases and record them in Table T-11.18 below. Also from note 6 we take the average of long term obligations interest rate of 9.3 %. Table 11.18 presents the calculation of the present value of operating leases calculated at a discount rate of 9.3% (under the assumption that the alternative that Delta would have to own the aircraft currently under operating leases would be to borrow at its average long term rate).
The implied interest expense is also calculated with the long term rate of 9.3%. Implied interest = 9,471 x 0.093 = 880.80 or $ 881 millions After inclusion of operating lease implied interest, Delta's interest coverage become TIE' = 1,870 / (199+881) = 1,870 / 1080 = 1.73 This interest coverage is clearly not as impressive as the previous one. It illustrates the magnitude of operating leases in Delta's financial strategy. Other major airline rely on operating leases just as much as Delta, if not a great deal more. UAL's times interest earned is 3.84 in 1999, but it becomes 0.82 when operating lease implied interest is included. Likewise, AMR's times interest earned of 6.28 becomes 1.67 when operating lease implied interest is included. |
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Bankers want to know if a borrower will be able to pay not only interest but the principal installments as well. The ratio that is used is called the debt servicing coverage ratio, and is often calculated with cash flow rather operating profit. In the latter case, it is called cash flow coverage CFC:
CFC = Cash flow from operations / (Interest + (repayment (1/(1-t))))
Any value of this ratio less than one is obvious cause for alarm. Note that the repayment of principal (which is paid out of cash on the balance sheet, and not expensed through income statement) has to be converted into its pre-tax equivalent when combined with interest (which is a pre-tax expense). Repayment is, therefore, divided by one minus the corporate income tax rate.
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We continue with J.C. Penney to demonstrate the calculation of this ratio. From J.C. Penney Consolidated Statement of Cash Flows, we take the amount of cash flow from operating activities of $ 1,058 millions in 1998, and the amount of repayment of long term debt of $ 478 millions. As before, interest expense was $ 480 millions. To obtain the cash flow from operations before interest expense we add back income taxes of $ 361 millions and interest expense, for a total of $ 1,899 millions. The effective corporate income tax rate in 1998 was 37.8% (i.e. 361/955 as shown in Table T-6.9 - J.C. Penney Company Inc. - Income Statement). This gives a cash flow coverage of CFC = 1,899 / (480 + 478 /(1-.378)) = 1,899 / (480 + 768) = 1,899 / 1248 = 1.52 The cash flow coverage ratio of 1.52 indicates that J.C. Penney in 1998 generated sufficient cash flows from operation to cover its debt servicing. There is certainly not much room for freedom of action. After investigation, however, a note to the financial statements revealed that 1998 cash flows from operations were applied to an increase of $ 521 millions in receivables at Eckerd (an affiliate running a chain of pharmacies) and a reserve established in 1997. It would be appropriate to compare J.C. Penney cash flow coverage with those of its major competitors. As an example, we take Value City Department Stores, Inc. (a much smaller operation than J.C. Penney). It has a cash flow coverage of 1.46 in 1998. This is very much in line with J.C. Penney, and still border line. |
A coverage ratio may include any and all fixed charges, such as rent, insurance, fixed portion of utilities, depreciation, salaries of executives, franchise royalties, copyrights payments, and other fixed expenses. For instance a fixed charges coverage FCC ratio that would include interest and rent, would be
FCC = Earnings before rent, interest and taxes / Rent and interest expenses
This ratio is necessarily lower than times interest earned. A value 3 or above is desirable, as demonstrated by Hickman's bankruptcy predictor based on fixed charge coverage empirical evidence in next section.
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For this example, we turn to Delta Air Lines. From Table T-6.11 - Delta Air Lines - Income Statement, we take the amounts for operating income of $ 1,870 millions in 1999 and interest expense of $ 199 millions. From the details of the income statement in the Annual Report, Delta reports aircraft rent of $ 590 millions and landing fees and other rents of $ 707 millions. These two expense items are most likely fixed charges, others do not appear to be so. The fixed charges coverage ratio is thus FCC = (1,870 + 590 + 707 ) / (199 + 590 + 707) = 3,167 / 1,496 = 2.12 The fixed charges coverage ratio of 2.12 in 1999 indicates that Delta has no trouble covering its fixed charges, but there isn't much room to spare and the ratio falls short of Hickman's requirement. Yet, this fixed charges coverage is better than what is was in the previous years: 2.08 in 1998 and 1.94 in 1997. Comparing Delta's fixed charges coverage with that of some of its direct competitors, we find that competitors had more difficulty covering their fixed charges. UAL fixed charge coverage ratio was only 1.47 in 1999, and 1.52 and 1.40 the two previous years. AMR had a fixed charge coverage ratio of 2.08 in 1998 and 1.79 the year before. |
Another payment that is considered as fixed, is preferred stock dividends. Since the firm is obliged to pay preferred stock dividends as long as it has sufficient earnings, this should also be included in a comprehensive coverage ratio. Dividends are paid from profits after tax, and, therefore, (just as the repayment of debt principal), preferred stock dividends payment must be converted into its pre-tax equivalent by dividing by one minus tax rate.
The coverage ratio required to be
reported by the SEC in the United States is known as Ratio of
Earnings to Fixed Charges (REFC). Its denominator includes as
fixed charges FC
- total interest expense with all implicit interest (such as on
leases), and without netting by interest income, but net of interest
that is capitalized (i.e. not expensed that year)
- amortization of bond discount
- pre-tax equivalent of preferred stock dividend
In the numerator, to the operating earnings EBIT are added back
the fixed charges FC as required, and, in addition, the income
of less than 50% owned subsidiaries Isub is deducted.
REFC = (EBIT + FC - Isub ) / FC
See review questions Q-11C4.1 through Q-11C4.11.
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