1. Corporate Finance Lecture 5
Dr. Solt Eszter
BME
2017

2. Different ratios often tell you similar things
Financial Ratios
What do they measure?
Leverage Ratios: the indebtedness of the firm
Liquidity Ratios: how easily the firm can obtain cash
Efficiency Ratios: how intensively the firm is using its assets
Profitability Ratios: the firm’s return on its investments
Different ratios often tell you similar things

3. BALANCE SHEET FOR PEPSICO, INC. (in millions of dollars)
Assets
Liabilities and
Shareholders’Equity
Current assets
Cash and equivalents ,928
Marketable securities
Receivables , ,150
Inventories ,
Other current
assets
Total current assets 4, ,251
Fixed assets
Property, plant and
equipment , ,294
Less depreciation , ,033
Net fixed assets , ,261
Intangible assets 8, ,855
Other assets , ,734
Total assets , ,101
Current liabilities
Debt due for repayment 3,
Accounts payable , ,617
Other current liabilities
Total current liabilities , ,257
Long-term debt , ,946
Other long-term liabilities 4, ,962
Total liabilities , ,165
Shareholders’ equity
Common stock
and other paid-in capital 1, ,343
Retained earnings , ,593
Total shareholders’ equity 6, ,936
Total liabilities
and shareholders’ equity 22, ,101

4. Financial leverage Financial risk
Financial leverage: the degree to which a company uses fixed-income securities such as debt and preferred equity.
The more debt financing a company uses, the higher its financial leverage. A high degree of financial leverage means high interest payments, which negatively affect the company's bottom-line earnings per share (EPS).
Financial risk: the risk to the stockholders that is caused by an increase in debt and preferred equities in a company's capital structure. As a company increases debt and preferred equities, interest payments increase, reducing EPS. As a result, risk to stockholder return is increased. A company should keep its optimal capital structure in mind when making financing decisions. 
Leverage ratios measure how much financial leverage the
firm has taken on

5. Leverage Ratios Long-term Debt Ratio
This is the ratio of long-term debt to total long-term capital
long-term debt include bonds or other borrowing and the value of long-term leases (long-term rental agreement)
total long-term capital is the sum of long-term debt and shareholders’ equity =(total capitalization) that is:
Long-term debt ratio:
long-term debt/long-term debt + equity
for Pepsi: 4,028/4, ,401 = .39
This means that 39 cents of every dollar of long-term capital is in the form of long-term
debt

6. Leverage Ratios Debt-Equity Ratio
Another way to express leverage:
Debt-equity ratio:
long-term debt/equity
for Pepsi: 4,028/6,401 = .63
the market value of the firm includes the value of intangible assets generated by research and development, advertising, staff training, etc. These assets are not readily saleable and, if the company falls on hard times, the value of these assets may disappear altogether
when banks demand that a borrower keep within a maximum debt ratio, they usually define this debt ratio in terms of book values)

7. Leverage Ratios Total Debt Ratio Total Debt to Equity Ratio
includes all liabilities:
Total debt ratio:
total liabilities/total assets
for Pepsi: 16,259/22,660 = .72
This means that Pepsi is financed 72 percent with debt, both long-term and short-term, and 28 percent with equity
Total debt to equity ratio:
total liabilities/equity
16,259/6,401 = 2.54

8. Leverage Ratios Times Interest Earned Ratio (or: interest cover ratio)
the extent to which interest is covered by earnings
calculated because banks prefer to lend to firms whose earnings are far in excess of interest payments
This is: the ratio of Earnings Before Interest and Taxes (EBIT) to interest payments:
Times interest earned = EBIT/interest payments
for Pepsi: 2,581/321 = 8.0
This means that Pepsi’s profits would need to fall dramatically before they were insufficient to cover the interest payment. But it doesn’t tell us whether Pepsi is generating enough cash to repay its debt as it becomes due.

9. INCOME STATEMENT FOR PEPSICO, INC., 1998 (in millions of dollars)
Net sales
Cost of goods sold
Other expenses
Selling, general, and administrative expenses
Depreciation
Earnings before interest and taxes (EBIT)
Net interest expense
Taxable income
Taxes
Net income
Allocation of net income
Addition to retained earnings
Dividends
$22,348 9, ,912 1,234 2, , ,990 1,

10. Leverage Ratios Cash Coverage Ratio
It measures the extent to which interest is covered by the cash flow from operations
(depreciation is deducted when calculating the firm’s earnings, even though there is no cash outflow)
Cash coverage ratio = EBIT + depreciation/interest payments
for Pepsi: 2, ,234/321 = 11.9

11. Test1
A firm repays $20 million par value of outstanding debt and issues $20 million of new debt with a lower rate of interest. What happens to its long-term debt ratio? What happens to its times interest earned and cash coverage ratios?

12. Answer
Nothing will happen to the long-term debt ratio (long-term debt/long-term debt + equity) computed using book values, since the face values of the old and new debt are equal. The times interest earned (EBIT/interest payments) and cash coverage ratios (EBIT + depreciation/interest payments) will increase since the firm will reduce its interest expense.
Face value: the nominal value or dollar value, also known as par value