Genesis Management Services Pty Ltd gmservices.com.au
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UNIT 7. MANAGING LONG TERM FINANCES
We have said before that the three key dimensions of financial management are profitability, liquidity and security. Our long term finances have to be managed effectively to preserve the long term financial structure of the business.
Security refers to having a reasonable foundation on which to build the financial structure of the business. This foundation has to be solid and not prone to cracking in unusual circumstances.
Sources of Long Term Finance
Long term finance is of two kinds, long term liabilities and capital. The former represents borrowing’s from outsiders whilst the latter represents funds supplied indefinitely by the owners of the business and includes profit that has been accumulated.
The people who we have borrowed money from (lenders) expect their money back at a predetermined time whereas those that have provided capital invested in the business for the long term do set a date for repayment of that capital.
The majority of shareholders can vote for a partial return of capital if surplus capital is available or even for a liquidation which may or may not yield a full capital return.
Normally we don't invest anticipating a liquidation. If a shareholder wants to convert his shares into cash the best avenue is to sell those shares to somebody else. This does not affect the company which is a separate legal entity.
Security refers to the relationship between long term liabilities and capital. The higher the former the less secure the financial foundation of the agency (financial structure). Long term liabilities are attractive because we can borrow to finance investments which hopefully will provide for improved profitability. But they place a burden on the agency in that the business has to meet definite commitments for interest and principal repayments. These have to be paid when they fall due just as the balance of the principal has to be paid at the end of the borrowing period.
We have all read about the corporate high flyers in 1990 who were not able to re-finance their borrowing’s because of the poor outlook in the property market and therefore had to suffer a forced sale of their assets and even liquidation so the lenders could be repaid.
So we have to have in mind not only the outlook for the operations of the business but also the outlook in the funds market concerning the conditions for supply and demand for funds.
As a general rule we should never borrow long and invest short. If we are wanting to invest in long term fixed assets we should never borrow short. We should finance these investments with long term borrowing’s. The mix of short vs. long term funds is critical.
Uses of Long Term Finance
There are several alternative uses to which long term finance might be put. It could be used:
to replenish working capital (increase current assets and/or reduce current liabilities).
This is not normally recommended because we should not borrow long to invest short. It is done in a crisis with a view to restoring profitability so that (hopefully) future profit can generate the necessary funds to repay the loan or to attract new borrowers or shareholders for replacing the loan funds.
for investment in fixed assets
for replacing other long term borrowing
to finance a return of capital. (This is only done in extreme cases).
Measuring Long Term Debt Capacity
In our Travel 'n' Tour case study the figures concerning long term debt capacity for 1990 are as follows:
Long Term Loan 80
Capital 259 (Capital at beginning 70 plus retained profit 189)
Total Long Term Funds 339
In percentage terms the long term loan (debt) is 23.5% of long term funds. Normally however we relate long term loans not to total funds, but to capital.
The answer then is .31 (or 31%). Therefore 80 compared with 259 is .31 or 31%. We have then to decide whether a ratio of .31 is good or bad. As a general rule we like to see a ratio of .5 meaning that 50% of the long term funds are provided externally and 50% are provided internally. This means that we can easily pre-determine long term debt capacity in reference to the amount of capital in the business. In our example in 1990 our debt could be increased by 179 to 259 if the desired standard were a debt:equity ratio of 1.
Debt:equity ratios are often referred to as "gearing" or "leverage" ratios. We talk of companies being highly geared where their long term debt is far greater than their capital base and conversely of being lowly geared when it is only a fraction of the capital base.
CASE STUDY
To help you get a better appreciation of managing long term finance we continue working with our case study "Austral Travel Agency". The financial statements for this agency were set out in Unit 6. Here is an illustrative analysis.
Debt to Equity
Long Term Debt = 27,700 = .4:1 (or 40.7%)
Shareholders Funds 68,000
Total Debt to Total Assets
This is another measure of leverage.
Total Debt x 100 = 52,000 x 100 = 43.3%
Total Assets 1 120,000 1
Thus 43.3% of total assets are financed by the firm's short and long term liabilities. In the event of liquidation these outsiders will have a preferential claim on assets and so before lending money or providing credit these people like to look at this ratio to comfort them that the level of shareholders' funds provides them with the necessary safety margin. In our example our assets need only realise 43.3% of their book value to secure a full return of money to these outsiders.
Shareholders are attracted to the idea of using outsiders' funds to increase the ROI on their capital. They can usually do this without surrendering control of the business. However the situation can change dramatically for firms with high debt (high leverage/high gearing) when business slumps. The attraction of stimulating ROI when business is booming by extensive borrowing is completely overshadowed by the consequences of serving that extra debt when losses occur in a business slump.
Debt to Operating Cash Flow
This ratio relates the company's long and short term borrowing’s to its operating cash flow (defined as Profit after Tax plus Depreciation). We have to remember that depreciation is a book entry and is not a funds item. It relates to purchase of a fixed asset some time in the past.
The only impact on funds was when that asset was originally purchased.
In our profit & loss statement for Austral Travel Agency under the expenses heading was included an item for depreciation $8,000. Also in the balance sheet our total debt is listed as long term liabilities $27,700 plus current liabilities $24,300. Thus our total debt includes short and long term debt.
Total Debt = 52,000 = 2.6 years
Operating Cash Flow 12,000 + 8,000
The company will take 2.6 years to redeem all of its debt using operating cash flows, providing that:
there will be no further borrowing;
profits remain constant; and
there will be no dividend payments.
Times Interest Coverage
One of the greatest risks to the survival of the business is defaulting on an interest payment when it falls due, usually prompting an immediate call up of the loan and if alternative finance is not arranged then a forced sale of assets proceeds. We have therefore a need to measure how well our earnings are able to satisfy interest payments.
Net Profit before Tax 19,800
add back Depreciation 8,000
Net Profit before Interest & Tax (EBIT) 27,800
EBIT is shorthand for earnings before interest and tax.
Times Interest Coverage = EBIT = 27,800 = 6.2 times
Interest 4,500
The lower this ratio the less capacity the company will have to meet its interest payments.
Fixed Charge Coverage
Sometimes companies like to incur a lot of fixed charges in the form of lease payments as an alternative way of financing the use of assets.
Fixed Charge Coverage = EBIT plus lease costs
interest and lease costs
= 24,300 + 9,000 = 33,300 = 2.47
13,500 13,500
This ratio helps answer the problem presented by the times interest coverage ratio which ignores the impact of lease obligations.
Net Asset Backing
Sometimes prospective lenders like to take a hard look at the underlying value of the business to see to what extent the shares of the company are covered by the current value of net assets.
This approach is used as one method of valuation also by valuers and others who are trying to value the business.
Net asset backing looks at total assets, including intangible assets.
Total Assets 120,000
less Liabilities 52,000
Net Assets 68,000
68,000 68,000 = $1.36 per share
50,000 shares
Net tangible asset backing excludes goodwill.
60,000 60,000 = $1.20 per share
50,000 shares
Goodwill is excluded because in the event of liquidation it usually has no value. Other intangible assets that are normally excluded are trademarks, formation expenses, patents, etc.
Copyright © Bill Wright 1994