TOOL E14
The “Debt Service and Liquidity” component of financial risk analysis provides insight into the quality of a client’s operating cash flows; the ability of the client to meet all business-related and financial charges from ongoing cash flows; and the ability to tap alternate sources of internal and external sources of funds to meet all current and contingent obligations when they become due. This tool will help you understand and interpret the non-financial reasons that drive the metrics associated with “Debt Service and Liquidity”; identify one-off factors; consider accounting policies that impact the reported numbers; and be mindful of internal spreading errors that may distort these metrics.
WHICH RATIO TO USE?
Each of the ratios below compares a measure of cash flow either to a certain combination of financing charges. Which one you select will depend on:
• the trend / risk message you wish to analyse. Be clear on whether you are trying to assess actual cash flow or sustainable cash flow;
• the volatility of the Asset Conversion Cycle (working capital);
• the difficulty in distinguishing between mandatory and discretionary CAPEX;
• the debt maturity profile.
CASH FLOW METRICS
Tool: Cash flow drivers
| 1. P | A measure of operating cash flows | The Profit cash driver. This considers the core operating cash flow before including the financing of ACC and Capex. Be clear whether it is measured including or excluding non-recurring items, operating leasing, interest and tax. |
| 2. P +/- A | A measure of operating cash flows +/- changes in ACC or W/C | The Profit cash driver combined with ACC. Be clear whether you are only including ACC items or all Working Capital (WC) items (excluding cash and debt). In particular are related party items included in WC. Note to what extent non ACC items in WC are non-recurring. |
| 3. P +/- A – C | A measure of operating cash flows +/- changes in ACC or W/C and less CAPEX | Deduct gross CAPEX from either the profit cash driver or from the combined Profit and ACC cash drivers. Note when sale proceeds from CAPEX are regular, net CAPEX may be a more realistic sustainable figure. In some cases you will be able to work with mandatory CAPEX only. |
| 4. P +/- A – C – Divs | A measure of operating cash flows after changes in ACC or W/C, CAPEX, and Dividends | In some cases analysts prefer to deduct dividends from cash flow to assess how much cash is retained in the business. Others include it in financial charges. The more you view dividend as mandatory the more convincing the case to include them in financial charges. |
FINANCING CHARGE METRICS/ DEFINITIONS
Note:
! Make sure if interest, operational leasing, and dividends are included in financing charges then the measurement of the Profit cash driver is done before these items (to avoid double counting).
! To assess the cash flow leverage of a client it might sometimes be preferable to place dividends and operating leasing in financial charges rather than deduct them from cash flow. You then have a clear indication of how much cash the client needs to generate to be able to fully service all of its financial charges.
Cash Flow Interest Coverage
| Typical Ratio | Interpretation | One-off Factors | Accounting Policies | Internal Spreading |
|---|---|---|---|---|
| Profit cash drive before Interest Costs Cash interests |
• A company’s ability to service its cash interest charges after paying operating leases and taxes but before financing ACC, Capex or Dividends • Assumes no scheduled principal repayment or ability to refinance • Assumes dividends are truly non-mandatory (caution!) |
• Check for non-recurring items • Changes in earnings or reported cash flow as a result of changes in consolidation • Large cash spent from provisions |
• This cash flow measure can be distorted by inventory valuations. (Corrected once ACC included) • Correct treatment of OP Leases; securitizations; capitalised interest; pension discounting • Be clear whether the GAAP used places interest in the operational cash flow or financing cash flow. • Are adjustments needed for minority interests? • Care with consolidation and transfer pricing |
• Have operating lease payments, capitalised interest, securitizations, and deferred tax all been captured correctly? • Is interest paid gross and not ‘net’? |
Debt Service Capacity
| Typical Ratio | Interpretation | One-off Factors | Accounting Policies | Internal Spreading |
|---|---|---|---|---|
| Profit & ACC drivers before Interest Costs Cash interests Be clear. Is it +/-change in ACC or +/- changes in WC |
• As with Profit Cash driver above except it is now after financing of ACC or WC depending on definition • If WC used then the emphasis is more on the actual ability to service rather than its sustainability. |
• As with Profit Cash driver above • Unusual year end movement in receivable, inventory and payables • If WC used unusual year end movements in other items in WC especially related party items | • As with Profit Cash driver except you are now protected against any impact from Inventory movements. |
• As with Profit Cash driver above • Have related party items been separately identified in Current Assets and Liabilities |
| Profit (ACC) & CAPEX Cash Driver Before Interest Costs Cash Interests |
• Inclusion of ACC preferable but may not be practical due to ACC volatility • As with ratios above except it is now after financing Capex. • The key question is to what extent Capex is mandatory or discretionary and needed for future growth. |
• As with ratios above • Volatile Capex/Unusual level of capex. Distinguish between mandatory Capex & growth Capex • Unusual level of Capex (mandatory vs. growth • Care in case of companies whose strategy is to achieve growth through external acquisitions & therefore is not reflected in Capex • A variant of this measure is to use maintenance Capex instead of gross Capex and/or to reflect acquisitions as a Capex | • As with ratios above |
• As with ratios above • Has Gross Capex been calculated correctly? |
| Profit Cash Driver before Interest + Op Leases Financial Charges |
• A company’s ability to service all or some of its financial charges after payment of tax and before financing ACC and Capex • Financing charges defined as cost of debt; cost of equity; operating and financial leases; principal pmt • If stable and providing an adequate cushion: company is a solid operating cash generator • If volatile: indicator of high business risk • May also indicate a ‘lumpy’ debt maturity structure or high dividends • Care with what is included/ excluded in Profit Cash driver • A ratio less than 1 means that the company needs other sources of funding to meet principal amortization obligations. |
• See Cash Flow Interest Coverage ratios above • Unusual level of s/t maturities • Unusual level of dividends |
• See Cash Flow Interest Coverage ratios above • Check whether the GAAP used places interest in the operational cash flow or financing cash flow |
• See Cash Flow Interest Coverage ratios above • Have current maturities (previous year) been shown separately? • Have operating lease payments, capitalised interest and deferred tax all been captured correctly? • Have dividends due been shown separately in Current Liabilities? • Consider non cash /operating items. cash spent on provisions, impact of other current assets and liabilities and Capex |
| Profit (ACC) & Capex Cash drivers before interest + Operating Leases Financial Charges |
• A company’s ability to service all or some of its financial charges after financing of tax and ACC and before financing Capex • Financing charges defined as cost of debt; cost of equity; operating and financial leases; principal pmt • See other points above. |
• See above • Volatile / unusual changes in ACC • Unusual change in other current assets and liabilities. • See Cash Flow Interest Coverage ratios above |
• See above. • Note you have the benefit of being protected against inventory valuation | See above |
| Profit (ACC) & Capex Cash drivers before interest + Operating Leases Financial Charges |
• A company’s ability to service all or its financial charges after financing of tax, (ACC) and Capex • Financing charges defined as cost of debt; cost of equity; operating and financial leases; principal pmt • See other points above | • See Cash Flow Interest Coverage ratios above | See above | See above |
