Corporate Funding was developed on Jul.24, 2024.
CFO Handbook: Part 1, Chapter 2 - Funding
First revision: Jul.24, 2024
Last change: Aug.27, 2024
Searched, gathered, Rearranged, and Compiled by Apirak Kanchanakongkha.
Figure 2.1 Financing a Company
page 19
If the company has abundant earnings, the owners reap all that remains of the earnings after the creditors have been paid. If earnings are low, the creditors still must be paid what they are due, leaving the owners nothing out of the earnings. Failure to pay interest or principle as promised may result in financial distress. Financial distress is the condition where a company makes decisions under pressure to satisfy its legal obligations to its creditors. These decisions may not be in the best interests of the owners of the company.
With equity financing there is no obligation. Though the company may choose to distibute funds to the owners in the form of cash dividends, there is no legal requirement to do so. Furthermore, interest paid on debt is deductible for tax purposes, whereas dividend payments are not tax deductible.
One measure of the extent debt is used to finance a company is the debt ratio, the ratio of debt to equity:
Debt
Debt ratio = -----------
Equity
This is a relative measure of debt to equity. The greater the debt ratio, the greater the use of debt for financing operations, relative to equity financing. Another measure is the debt-to-asset ratio, which is the extent to which the assets of the company are financed with debt:
Debt
Debt-to-assets ratio = -----------
Total Assets
This is the proportion of debt in a company's capital structure, measured using the book or carrying value of the debt and assets.
It is often useful to focus on the long-term capital of a company when evaluating the capital structure of a company, looking at the interest-bearing debt of the company in comparison with the company's equity or with its capital. The capital of a company is the sum of its interest-bearing debt and its equity. The debt ratio can be restated as the ratio of the interest-bearing debt of the company to the equity:
page 20
Interest-bearing debt
Debt-equity ratio = -------------------------
Equity
and the debt-to-assets can be restated as the proportion of interest-bearing debt of the company's capital:
Interest-bearing debt
Debt-to-capital ratio = -------------------------
Total capital
By focusing on the long-term capital, the working capital decisions of a company that affect current liabilities, such as accounts payable, are removed from this analysis.
The equity component of all of these ratios is often stated in book or carrying value terms. However, when taking a markets perspective of the company's capital structure, it is often to compare debt capital with the market value of equity. In this latter formulation, for example, the total capital of the company is the sum of the interest-bearing debt and the market value of equity.
If market values of debt and equity are the most useful for decision making, should the CFO ignore book values? No, because book values are relevant in decision making also. For example, bond covenants are often specified in terms of book values or aratios of book values. As another example, dividends are distinguished from the return of capital based on the availability of the book value of retained earnings. Therefore, though the focus is primarily on the market values of capital, the CFO must keep an eye on the book value of debt and equity as well.
There is a tendency for companies in some sectors and industries to use more debt than others. We see this looking at the capital structure for different sectors from a survey & study information, where the proportion of assets financed with debt and equity are shown graphically in terms of the book values of debt and equity. We can make some generalizations about differences in capital structures across sectors:
- Companies that are more reliant upon research and development for new products and technology - for example, pharmaceutical companies - tend to have lower debt-to-asset ratios than companies without such research and develpment needs.
- Companies that require a relatibely heavy investment in fixed assets tend to have lower debt-to-asset ratios.
It is also interesting to see how debt ratios compare within sectors and with industries in a sector. For example, within the utilities sector, the electirc utility industry has a lower use of debt than both the water and gas industries.
page 21
Yet within each industry there is variation of debt ratios. For example, within the beverage industry, Cott Corporation, maker of retail-brand soft drinks, has a much higher portion of debt in its capital structure than, say, the Coca-Cola Company.
Why do some industries tend to have companies with higher debt ratios than other industries? By examining the role of financial leveraging, financial distress, and taxes, we can explain some of the variation in debt ratios among industries. And by analyzing these factors, we can explain how the company's value may be affected by its capital structure.
CONCEPT OF LEVERAGE
The capital structure decision involves managing the risks associated with the company's business and financing decisions. The concept of leverage - in both its operations and its financing - plays a role in the company's risk because leverage exaggerates outcomes, good or bad.
page 22
Consider the simple example of a company that has both fixed and variable expenses. Suppose it has one product, with a sales price of Thai Baht (THB) 100 per unit and variable costs of Thai Baht 40 per unit. This means that the company has a THB 60 profit per unit before considering any fixed expenses. This THB 60 is the product's contribution margin - the amount that is available to cover any fixed expenses. Suppose the company's fixed expenses are THB 20 million. If the company produces and sells 250,000 units, it has a loss of THB 5 million; whereas if it produces and sells 1 million units, it has a profit of THB 40 million.
