Interest Coverage And Debt Service Coverage example essay topic

Financial leverage is using OPM (Other People's Money) to improve Return On Equity (ROE.) rather than utilizing owners equity. If a company can borrow money at a rate lower than the return on assets or ROI then the owners' equity position will be improved. This occurs because less of the equity is required to purchase assets. Improving Return on Equity Consider a company who has expected earnings before interest and taxes (EBIT) of $500,000 and needs to obtain $1 M in new financing either through the sale of 50,000 shares of common stock or obtaining a long-term loan at 10% interest. Total assets of the company are $4.2 M and the corporate tax rate is 30%. Note that the interest on the debt reduces the company's tax burden by 20 percent.

This indicates that the debt represents a "lower economic cost to the firm than owners' equity". (Marshall, McManus, and Viele, 2001) Also, since no new shares were issued the existing shareholders not only see a 28% return on their investment they experience no dilution in their ownership stake in the company. The downside risks Financial leverage can, however, represent a substantial risk to the company including increased volatility in earnings per share, potential default, or bankruptcy. While financial leverage can bring about significant gains in return on equity from operating efficiencies, greater production capacities, or higher sales volume the adverse is equally true. If earnings before interest and taxes (operating earnings) fall due to a recessionary cycle or slump in the market, a heavy debt burden can have a drastic impact on the company's ability to compete or survive.

Market Volatility Debt at any level increases the potential for instability in earnings per share (EPS). The more debt, the more variable EPS is likely to become. This variability in EPS translates into market price instability. As a company takes on a higher ratio of debt to equity, the volatility of the market price of the stock increases due to the increased nervousness of the shareholders. The reality is that earnings expectations directly impact the price of the stock. (Petr off, 2000) Default The key to successfully leveraging debt is increasing operating earnings.

If the anticipated revenue increase fails to occur for any reason then the company may be unable to service the debt. Even potential default by a company can have disastrous results. Additional debt will be more difficult to obtain; certainly it will come at higher cost. Lenders will place restrictions on what the company can do with any borrowed funds. Another ramification to potential default is the limitations it places on management.

The ability to improve customer service or to stay ahead of competitors is hampered by the inability to take on additional debt. It also raises the potential risk of bankruptcy. Potential investors will be less likely to invest when the debt level is too high. Investors and financial analysts look at two key indicators or coverage ratios: Interest coverage and Debt-service coverage. Interest coverage is determined by dividing operating earnings by interest expenses. Obviously the resulting number should be as high as possible.

Debt-service coverage is a direct indicator of the company's ability to meet debt payments. It is determined by dividing operating earnings by the interest plus the principle payments after converting to pre-tax dollars. The higher the resulting number is the more likely the company will be able to service the debt. Bankruptcy Actual default may lead a company into bankruptcy. Even the possibility of bankruptcy can have deleterious results; from employees who abandon a sinking boat to customers who refuse to purchase the company's products. Summary The proper use of financial leverage can significantly improve a company's return on earnings position.

Unfortunately, high levels of debt coupled with poor or insufficient increases in earnings can be disastrous, even fatal, for a company. Careful and prudent risk management is essential for management when taking on long-term debt.

Bibliography

Kuhlemeyer, G. (2001). Chapter 16: Operating and.