CHAPTER

7
CREDIT ANALYSIS
CAPITAL STRUCTURE AND SOLVENCY

Prepared by :
Sukjit Singh
815739
Ayushafiza Zulkifly
816248
Parimala Devi Ponnan
819260
Asiah Abd. Harith
816444
Prepared for:
Dr. Norshafizah Hanafi
BWFF 5033

FINANCIAL REPORTING AND STATEMENT ANALYSIS

Capital Structure and

Solvency CAPITAL
Analysis
BASIC OF
SOLVENC
Y

Capital
Structure
Motivation
for Debt
Financial
Leverage

STRUCTURE
COMPOSITION AND
SOLVENCY

Common size statement

Capital Structure Measures

Interpretation of Measures

Asset-Based Solvency Measures

EARNING
S
COVERAG
E

Introduction to
Earning
Coverage

BASIC SOLVENCY
PROFITABILI
TY

LIQUIDITY

SOLVENCY

DEVELOPME
NT

BASIC SOLVENCY
Solvency - refers to a companys long-run financial viability
and its ability to cover long-term obligations

Capital structure - financing sources and their attributes

Earning power - recurring ability to generate cash from
operations

Loan covenants - protection against insolvency and financial

distress; they define conditions of default at a level to allow
the opportunity to collect on a loan before severe distress

BASIC SOLVENCY
CAPITAL STRUCTURE

Equity financing
Risk capital of a company
Uncertain and unspecified return
Lack of any repayment pattern
Contributes to a companys stability and solvency

Debt financing
Must be repaid with interest
Specified repayment pattern

When the proportion of debt financing is higher, the higher are the resulting fixed charges and repayment commitments

BASIC SOLVENCY
MOTIVATION DEBT

From a shareholders perspective, debt financing is less expensive than equity financing because:

1.Financial Leverage--Interest on most debt is

fixed, and provided
interest is less than the
return earned from debt financing, the
excess return goes to equity investors.

2.Tax Deductibility of Interest--Interest is a taxwhereas dividends are

not.

deductible expense

BASIC SOLVENCY
FINANCIAL LEVERAGE

Financial Leverage Ratio

Total assets
Common equity capital

Greater the proportion of financing from equity vs. debt

lower the financial leverage ratio

Note: Financial leverage ratio is a component of the

disaggregated return on equity:
ROCE = Adjusted profit margin

Asset turnover

Leverage

Capital Structure Composition And

Solvency

Several measures - used to estimate

degree of financial leverage

Evaluate the risk of insolvency

Capital Structure Composition and

Solvency
Common-Size Statements in Solvency Analysis

Capital structure composition analysis

Performed by constructing a common-size
statement of liabilities and equity
Reveals relative magnitude of financing
sources
Allows direct comparisons across different
companies
Two Variations(1) Use ratios, and (2)
Long-term financing sources- Exclude
current liabilities

Capital Structure Composition and

Solvency
Common-Size Statements in Solvency Analysis

Capital Structure Composition and

Solvency

Total Debt to Total Capital Ratio

Comprehensive measure of the relation
between total debt and total capital
Also called Total debt ratio

Capital Structure Composition and

Solvency
Total Debt to Total Capital Ratio
Total Debt_
Total capital
Exp : Campbell soup (Year 11)
$1,278+772.6+305.0
$1793.4+2355.6
= 0.57

Debt constituting 57% of Campbell Soups capital

structure

Capital Structure Composition and

Solvency
Total Debt to Equity Capital
Total Debt_____
Shareholders equity
$ 2,355.6_
$ 1,793.4
= 1.31

Credit financing equals 1.31 for every $1 of equity

financing

Capital Structure Composition and

Solvency

Long-Term Debt to Equity Capital

Measures the relation of LT debt to equity
capital.
Commonly referred to as the debt to equity
ratio.

Capital Structure Composition and Solvency

Long Term Debt To Equity Capital
Long-term Debt__
Shareholders equity
$2,355.6-1,278_
$1,793.4
=0.60

A ratio in excess of 1.1 indicates greater long-term

debt financing compared too equity capital.

Capital Structure Composition and

Solvency

Short-Term Debt to Total Debt

Indicator of enterprise reliance on short-term financing.
Usually subject to frequent changes in interest rates.

Capital Structure Composition and Solvency

Interpretation of Capital Structure Measures
Common-size and ratio analyses of capital structure

mainly reflect capital structure risk

Capital structure measures serve as screening devices
Extended analysis focuses financial condition, results
of operations, and future prospects
Prior to long-term solvency analysis, we perform
liquidity analysis to be satisfied about near-term
survival
Additional analyses include examination of

Debt maturities (amount and timing)

Interest costs
Risk-bearing factors (earnings persistence, industry performance, and
asset composition)

Capital Structure Composition and Solvency

Asset-Based Measures of Solvency

Asset composition in solvency analysis

Important tool in assessing capital structure risk
exposure.
Typically evaluated using common-size statements of
asset balances.

Capital Structure Composition and Solvency

Asset-Based Measures of Solvency

Asset composition in solvency analysis

Important tool in assessing capital structure risk
exposure.
Typically evaluated using common-size statements of
asset balances.

Capital Structure Composition and Solvency

Common-Size Statements in Solvency Analysis
Capital structure composition analysis
Performed by constructing a common-size statement of
liabilities and equity
Reveals relative magnitude of financing sources
Allows direct comparisons across different companies
Two Variations(1) Use ratios, and (2) Long-term
financing sources- Exclude current liabilities

Capital Structure Composition and Solvency

Common-Size Statements in Solvency Analysis

Capital Structure Composition and Solvency

Total Debt to Total Capital Ratio

Comprehensive measure of the relation between total debt and total capital

Also called Total debt ratio

Capital Structure Composition and Solvency

Total Debt to Total Capital Ratio

Comprehensive measure of the relation between total debt and total capital

Also called Total debt ratio

Capital Structure Composition and Solvency

Total Debt to Total Capital Ratio
Total Debt_
Total capital
Exp : Campbell soup (Year 11)
$1,278+772.6+305.0
$1793.4+2355.6
= 0.57

Debt constituting 57% of Campbell Soups capital structure

Capital Structure Composition and Solvency

Total Debt to Equity Capital

Total Debt_____
Shareholders equity
$ 2,355.6_
$ 1,793.4
= 1.31

Credit financing equals 1.31 for every $1 of equity financing

Capital Structure Composition and Solvency

Long-Term Debt to Equity Capital

Measures the relation of LT debt to equity
capital.
Commonly referred to as the debt to
equity ratio.

Capital Structure Composition and Solvency

Long Term Debt To Equity Capital

Long-term Debt__
Shareholders equity
$2,355.6-1,278_
$1,793.4
=0.60

A ratio in excess of 1.1 indicates greater long-term debt financing

compared too equity capital.

Capital Structure Composition and Solvency

Short-Term Debt to Total Debt

Indicator of enterprise reliance on short-term financing.
Usually subject to frequent changes in interest rates.

Capital Structure Composition and Solvency

Interpretation of Capital Structure Measures
Common-size and ratio analyses of capital structure mainly reflect capital structure
risk
Capital structure measures serve as screening devices
Extended analysis focuses financial condition, results of operations, and future
prospects
Prior to long-term solvency analysis, we perform liquidity analysis to be satisfied
about near-term survival
Additional analyses include examination of
Debt maturities (amount and timing)
Interest costs
Risk-bearing factors (earnings persistence, industry performance, and asset
composition)

Capital Structure Composition and Solvency

Asset-Based Measures of Solvency

Asset composition in solvency analysis

Important tool in assessing capital structure risk exposure.

Typically evaluated using common-size statements of asset
balances.

Earnings Coverage
Earnings to fixed charges

Earning coverage measures focus on the relation between debtrelated fixed charges and companys earning available to meet this
charges.
Earning to fixed charges

Earnings Coverage
Times Interest Earned

Times Interest Earned ratio

Earnings Coverage
Interpreting Earnings Coverage
1)Earnings-coverage measures provide insight into the ability of a
company to meet its fixed charges

2)High correlation between earnings-coverage measures and

default rate on debt
3)Earnings variability and persistence is important
4)Use earnings before discontinued operations, extraordinary
items, and cumulative effects of accounting changes for
single year analysis-but include them in computing the
average ratio over several years

Earnings Coverage
Capital Structure Risk & Return

1) A company can increase risks (and potential returns) of

equity holders by increasing leverage
2) Substitution of debt for equity yields a riskier capital
structure
3) Relation between risk and return in a capital structure
exists
4) Only personal analysis can reflect ones unique risk and
return expectations

THANK YOU