This document discusses various leverage and solvency ratios used to evaluate a company's financial position, including: - Total debt to equity ratio, which compares a company's total liabilities to shareholders' equity. A high ratio indicates more risk. - Total debt to total assets ratio, which indicates the percentage of assets financed through debt. A ratio over 50% suggests high leverage. - Long-term debt ratios, which evaluate a company's long-term obligations relative to equity or total assets. - Times interest earned and operating cash to interest ratios, which measure a company's ability to meet interest payments from earnings or cash flows. Ratios below 2.5 generally indicate higher risk. The document also discusses

1. Leverage/Solvency ratios
Meeting 2

2. Leverage / Solvency Ratios
• Total Debt to Equity ratio
• Total Debt to Total Assets ratio
• Long term Liabilities to Equity ratio
• Long term Liabilities Total Assets ratio
• Times Interest earned
• Operating cash to Interest ratio

4. Leverage
• The use of debt as a source of capital
• The right amount of leverage can affect the company favourably.
• Too much debt can be unfavourable
• The greater the proportion of debt, the greater the leverage.
• The presence of debt increases a company’s risk or the higher the
leverage the higher the risk

5. Total Debt to Equity ratio (1) definition
Total Debt (or “ total liabilities” or “short debt + long debt”)
Stockholders’ equity
* The two components are often taken from the firm's balance sheet or
statement of financial position
• shows the proportion of equity and debt a firm is using to finance its
assets, and the ability for shareholder equity to fulfil obligations to
creditors.
• A high debt/equity ratio generally means that a company has been
aggressive in financing its growth with debt. Aggressive leveraging
practices are often associated with high levels of risk.

6. Total Debt to Equity ratio (2) example
• For example, suppose a company A has a total shareholder value of
$180,000 and has $620,000 in liabilities. Its debt/equity ratio is then
3.4444 ($620,000 / $180,000), or 344.44%, indicating that the
company has been heavily taking on debt and thus has high risk.
• Conversely, if it has a shareholder value of $620,000 and $180,000 in
liabilities, the company’s D/E ratio is 0.2903 ($180,000 / $620,000), or
29.03%, indicating that the company has taken on relatively little debt
and thus has low risk.

7. Total Debt to Equity ratio (3) limitations
• For example, capital-intensive industries such as auto manufacturing
tend to have a debt/equity ratio above 2,
• While companies like personal computer manufacturers usually are
not particularly capital intensive and may often have a debt/equity
ratio of under 0.5.
• D/E ratios should only be used to compare companies when those
companies operate within the same industry.
• For example, IBM's debt ratio is 220%, which means that creditors
have more than twice as much money in the company than equity
holders

8. Total Debt to Total Assets ratio aka Leverage
(1) definition
• As a measure of firm leverage, the academic research usually applies
the ratio of total debt over total assets.
• It is the sum of long and short term debt which represents all interest
bearing and capitalized lease obligations, so it is the most
comprehensive variable representing debt among others.
• This measure provides a good indication of financial leverage, since
total liabilities also includes items like accounts payable, which may
be used for transactions purposes rather than for financing.

9. Total Debt to Total Assets ratio (2) definition
Total Debt (or “ total liabilities” or “short debt + long debt”)
Total Assets
• Measures how leveraged a company is, meaning what percentage of its
assets are financed by debt.
• Is often used by management, analysts and investors to determine the
solvency of a company, or in other words, the ability of the company to
meet long-term obligations.
• One shortcoming of the total debt to total assets ratio is that it does not
provide any indication of asset quality, since it mixes all tangible and
intangible assets together.

10. Total Debt to Total Assets ratio (3) example
• For example, assume a company A has $40 million in long-term debt,
$10 million in short-term debt, and $100 million in total assets.
Company A would therefore have a total debt to total assets ratio of 0.5.
• 50% of Company A’s assets have been financed by debt.
• For example, say Company A has $100 million of total assets, and $40
million of total debt. Dividing total debt by total assets, we find its debt
ratio is 40%.
• This means 40% of Company A's assets are funded from borrowing.

11. Long-term debt (1)
• What Is Long-Term Debt on a Balance Sheet?
• The amount of long-term debt on a company's balance sheet refers to
money a company owes that it doesn't expect to repay within the
next twelve months.
• Long-term debt is a company’s financial obligations that will last a
year or longer.

12. Long-term debt (2)
• Long-term debt can consist of obligations such as mortgages on corporate
buildings or land, business loans underwritten by commercial banks, and
corporate bonds issued with the assistance of investment banks to fixed income
investors who rely on the interest income. Company executives, in conjunction
with the board of directors, often use long-term debt for several reasons
including, but not limited to:
1. Funding growth and acquisitions without diluting the stockholders;
2. Taking advantage of low-interest rate environments when it is possible to raise a
lot of money very cheaply, perhaps below the long-term rate of inflation once
income tax deductions have been taken into account, stockpiling it for future use;
and
3. Repurchasing shares through stock buy back programs so that the remaining
shares represent more ownership in the business.

13. Long term Liabilities (Debt) to Equity ratio
Long-term debt
Equity
• The greater a company's leverage, the higher the ratio. Generally,
companies with higher ratios are thought to be more risky.
• A high ratio usually indicates a higher degree of business risk because the
company must meet principal and interest on its obligations. Potential
creditors are reluctant to give financing to a company with a high debt
position.
• However, the magnitude of debt depends on the type of business. For
example, a bank may have a high debt ratio but its assets are generally
liquid. A utility can afford a higher ratio than a manufacturer because its
earnings are more stable.

14. Long term Liabilities (Debt) to Total Assets
ratio (1) definition
Long-term debt
Total Assets
• Shows the percentage of Company’s assets that are financed with long-
term debt.
• The ratio reveals a company’s general financial position.
• It shows the percentage of a company’s assets that are financed with loans
and other financial obligations that last over a year. As this ratio is
calculated yearly, decrease in the ratio would denote that the company is
fairing well, and is less dependant on debts for their business needs.

15. Long term Liabilities (Debt) to Total Assets
ratio (2) example
• For example, Corporation A has total assets, including cash, accounts
receivable, inventory and other items, that total $1 million. Its long-
term debts, including the leases on its facilities and its bond issues,
total $400,000.
• Its long-term debt to total assets ratio is 40%. In other words, for
every 40 cents Corporation A owes in long-term debt, it has $1 in
assets.

16. Times interest earned (TIE) (1) definition
Income before Interest and Taxes (EBIT)
Interest Expense
• is a metric used to measure a company's ability to meet its debt
obligations. TIE indicates how many times a company can cover its
interest charges on a pre-tax earnings basis.

17. Times interest earned (TIE) (2) limitations
• A ratio of 5 means the business is able to meet the total interest payments
owed on its outstanding, long-term debt five times over, or that the
business income is five times higher than the interest expenses owed for
the year.
• From an investor or creditor's perspective, an organization that has a times
interest earned ratio greater than 2.5 is considered an acceptable risk.
• A higher times interest earned ratio is favourable because it means the
company presents less of a risk to investors and creditors in terms of
solvency.
• Companies that have a times interest earned ratio of less than 2.5 are
considered a much higher risk for bankruptcy or default and therefore,
financial unstable.

18. Times interest earned (TIE) (3) limitations
• Although a higher times interest earned ratio is favourable, it does
not necessarily mean that a company is managing its debt repayment
or its financial leverage in the most efficient way. Instead, a times
interest earned ratio that is far above the industry average of a
business points to misappropriation of earnings.
• This means the business is not utilizing excess income for
reinvestment in the company through expansion or new projects, but
rather paying down debt obligations too quickly. For the long term, a
company with a high times interest earned ratio may lose favour with
investors.

19. Times interest earned (TIE) (4) example
• A is a construction company A that is currently applying for a new
loan to buy equipment. The bank asks A for his financial statements
before they will consider his loan. A's income statement shows that it
made $500,000 of income before interest expense and income taxes
(EBIT). A's overall interest expense for the year was only $50,000.
• A has a ratio of t10. This means that A's income is 10 times greater
than its annual interest expense. In other words, A can afford to pay
additional interest expenses. In this respect, A's business is less risky
and the bank shouldn't have a problem accepting loan.

20. Operating cash to Interest ratio
(Cash interest cover) definition
Operating cash flow
Interest paid
• A company's ability to pay interest due to its creditors is often measured
using interest cover (EBIT/net interest paid).
• However interest cover is calculated using accounting profits, which may
not accurately reflect the actual amount of cash inflows a company makes
its interest payments out of.
• For example, if interest is incurred but the actual payment is delayed, then
the cash interest cover may appear much better or worse than the real
picture. Cash interest cover is probably best used as a supplement to
interest cover rather than a substitute.

21. Capital structure CS (1) definition
• The way a corporation finances itself through debt or equity or the
composition of both

22. CS (2) Emerging markets
• There is evidence that firms in, such as Brazil and India, use equity
to finance their operations more than debt.
• Some of this dependence can be attributed to government
regulation that discourages the use of debt financing, either directly
by requiring the debt ratios to be below specified limits or indirectly
by limiting the deductibility of interest expenses for tax purposes.

23. CS (3) Pecking Order Theory
1. Internal funds (CASH)
2. External funds (DEBTS)
3. EQUITY

24. CS (4) in crisis times
• Firms tend to use internal funding and put more effort into
obtaining credit from banks, and anticipating restricted access to
credit in the future.
• However, government intervention through the monetary policy
during the financial crisis may make the cost of borrowing lower than
the cost of internal funds. Consequently, firms use debt before
internal funds.
• In crisis times the Pecking order theory predicts higher debt levels,
because opportunities for retained earnings have decreased due to
the crisis. Since debt is preferred over equity, a firm has to issue new
debt.

25. CS (5) in crisis times
• Leverage ratios from pre-crisis level to post-crisis level are not
significantly different from each other suggesting that post-crisis
leverage ratios revert back to similar levels as they were in the pre-
crisis period with an adjustment in the crisis period.

26. CS (6) in crisis times
• After the crisis companies had to waste the first immediately available for
use sources of financing such as internal funds (cash flows).
• That is the core prediction of the pecking order: companies use at first
their internal funds because of accessibility, and it is only after they
move towards debt financing and equity financing as a last resort, so the
Pecking order theory finds greater support after the crisis in my research.
• At the first approximation this decision shows, in other words, that
spending existing resources rather than obtaining loans from banks was
dictated by such external circumstances as an overall downturn of the
global market making them unable to generate high profits.

27. CS (7) in crisis times
• So it can be assumed that accumulating high cash flows before the
crisis somehow appeared as an “airbag”,
• Even though after the crisis the leverage level increased, companies
wasted cash flows accumulated previously, because they had to use
both sources of financing in the conditions of deep recession
and in their inability to generate profits which would make them
stay afloat.

28. CS (8) in crisis times

29. Enron scandal: Corporate Governance
• 7th Largest corporation in the USA (used to be)
• 22 thousands employees
• Bankruptcy
• Vice-president committed suicide
• Not because of hiding profits but Because of hiding debts (offshore
zones Cayman islands 692 companies)
• Fake financial statements
• Verb “enroning” – to hide debts by means of faking financial
statements