TOOL E11
The “Leverage & Debt Capacity” component of financial risk analysis provides insight into a client’s usage of – and reliance on – external funding, and its capacity to raise and support debt on a sustainable basis. This tool will help you understand and interpret the non-financial reasons that drive the metrics associated with “Leverage and Debt Capacity”; identify one-off factors; consider accounting policies that impact the numbers; and be mindful of internal spreading errors that may distort these metrics.
Asset Conversion Cycle (ACC)
| Typical Ratio | Interpretation | One-off Factors | Accounting Policies | Internal Spreading |
|---|---|---|---|---|
| SOLVENCY Net Worth (incl. intangibles/ Total Assets | • Balance between internal and external funding is shown • Greater financial risk & instability if deteriorating • Be clear why the ratio is deteriorating. Declining Net Worth showing lack of profit or aggressive dividends. Increasing assets indicating company is growing too fast for its resources • Low quality asset should be deducted from the numerator and denominator • Consider adjusting by adding off balance sheet items to Total Assets | • Care re seasonal businesses • Big investments • Debt / equity raising • Revaluation of assets • Acquired goodwill • Divestment of part of the business | • How is unpaid capital accounted for? • Have land & buildings been revalued? • Check revaluation translation and other parking reserves • Have there been changes in the valuation of assets? • Is there any off balance sheet leasing / debt? • What is the influence of goodwill? Tool: Accounting policies Tool: Creative Accounting | • Treatment of goodwill and intangibles • Impact of parking reserves including revaluation reserve • Treatment of dividends declared? |
| GEARING Total Debt / Tangible Net Worth | • See comments under solvency • Is an increase in debt due to heavy capital expenditure, or due to finance negative operational cash flow? • Has tangible net worth fallen because of retained losses, high dividends, acquisition or a share buy back? • Assumes intangibles are low quality assets • Gross debt preferred to Net Debt. If Net Debt used ensure cash figure is unrestricted | • See Solvency above • Debt might be unusually low while the balance sheet and payables and other liabilities are still growing rapidly | • See solvency above • Influence of hedge accounting on debt. Is it nominal or market value | • See solvency above • Has long term group debt been booked as short term group debt or accounts payable? • Has debt been classified as other liabilities? • Should debt include or exclude subordinated debt • Has debt been netted with cash? • Have intangible assets been shown as tangible assets? • Have off balance sheet items been indicated clearly? |
| GEARING (U.S.A.) Total Debt / Total Debt + Equity | • See comments under gearing above. • Be careful how you interpret the rate of change. Because debt is in both the numerator and denominator, any small change will represent a significant change in leverage. | See comments under gearing above | See comments under gearing above | See comments under gearing above |
Solvency/ leverage (Profit)
| Typical Ratio | Interpretation | One-off Factors | Accounting Policies | Internal Spreading |
|---|---|---|---|---|
| TOTAL DEBT / EBITDA Total Debt/ (Earnings Before Interest, Taxes, Depreciation and Amortisation) | • Must take into account impact of off-balance sheet items (especially leasing) on both Debt and EBITDA • Indicates whether debt is being used positively to create more EBITDA • Not an indicator of debt service capacity • Be clear whether the trend is being driven by changing debt levels or EBITDA levels • May be distorted by the time lag between assuming new debt, and a resultant improvement in the client’s profitability • Gross debt preferred to Net Debt. If Net Debt used ensure cash figure is unrestricted | • Big investments • Debt raising • Unusual year end debt levels | • See items related to debt under Solvency and Gearing. • See items related to operating margins | • See items related to debt under Solvency and Gearing • See items related to operating margins Tool: Ratio Analysis – Revenues & Profitability |
Solvency/ leverage (Cash Flow)
| Typical Ratio | Interpretation | One-off Factors | Accounting Policies | Internal Spreading |
|---|---|---|---|---|
| CASH FLOW / DEBT Certain levels of cash flow/ Total Debt. | • This will give you an idea of how much debt can be repaid from one year’s cash flow either before or after financing working capital, capital expenditure, dividends and financing costs. • Gross debt preferred to Net Debt. If Net Debt used ensure cash figure is unrestricted • May be distorted by the time lag between assuming new debt, and a resultant improvement in the client’s profitability | • Any unusual cash item in the income statement • Big changes / volatility in Working Capital Items, Capex, and dividends • Unusual level of debt | See items related to debt above | See items related to debt above Tool: Ratio Analysis – Debt Service & Liquidity Tool: Cash flow Drivers |
Tenor Matching
| Typical Ratio | Interpretation | One-off Factors | Accounting Policies | Internal Spreading |
|---|---|---|---|---|
| CURRENT RATIO Current Assets/ Current Liabilities | • To what extent is there a mis-match between the tenor of assets and funding? • Is there a shortening of the debt maturity profile? • Have cash / marketable securities been used to finance negative operational cash flow, or high capital expenditure? • Are cash / marketable securities building up as a result of good operational cash flow or one of injection from raising debt or the asset conversion cycle? • Sudden major decline may indicate a squeeze on the asset conversion cycle • See comments for receivables/ inventory / payables | • Unusual current maturities of long term debt • Incidentally high / low receivables, payable, inventory • High cash and equivalent from equity / debt raising • Unusual movements in other and related party current assets and liabilities • See receivable, payable and inventory days | • See comments under Receivable and Inventory days • Have fixed assets been reclassified as current? • Have current liabilities been reclassified as long term liabilities? | • Has cash been netted from debt? • Is there any restricted cash? (look in the notes) • Have current maturities of long term debt been shown separately? • Has short term debt been booked as long term debt? • Have dividends payable been shown as a current liability? • Are marketable securities liquid and readily saleable Tool: Ratio Analysis – Asset Management |
| QUICK RATIO Cash & Equivalents + Receivables / Current Liabilities | • See comments under Current Ratio above. • Indicator of how much the current ratio is impacted by inventory valuation. • A decline in this ratio indicates potential liquidity crisis due to a quicker collection of receivables or stretching of liabilities. • Check cash flow and Asset Conversion Cycle | See comments under Current Ratio above | See comments under Current Ratio above | See comments under Current Ratio above |
