8.8 A Company’s Debt-Paying Ability

Advantages and Disadvantages of Debt vs. Equity Financing

Managers must decide how to get the money needed to fund business activities (e.g., acquisitions, expansions, etc.).

There are three main ways to finance business activities:

Use excess cash not needed for operating activities (retained earnings);
Raise capital by issuing shares (equity financing); or
Borrow money using loans, bonds, or notes (debt financing).

comparing issues shares versus issuing debt
Issuing Shares	Issuing Debt
Dividends are optional	Interest and repayment of principal are required
More flexible cash outflow	Less flexibility in cash outflow
Dividends are not an expense	Interest is an expense
Not tax-deductible	Tax-deductible
No increase in liabilities	Increases credit risk
No covenant constraints	Debt convenant constraints
Dilutes control and earnings per share of exisiting shareholders	Does not dilute control or earnings per share of existing shareholders

Earnings per Share

Earnings per share (EPS) is the amount of a company’s net income earned per issued share. EPS is useful for evaluating earnings performance and assessing the impact of various financing options on earnings.

$$\text{EPS} = \frac{\text{Net Income}}{\text{Average # of Common Shares}}$$

Suppose a company needs $500,000 for expansion. Assume it has net income of $300,000 and 100,000 common shares outstanding. Management is considering two financing plans:

(1) Plan 1 is to issue $500,000 of 6% bonds payable, and

(2) Plan 2 is to issue 50,000 common shares for $500,000 ($10,000/share).

Management believes the new cash can be invested in operations to earn income of $200,000 before interest and taxes.

In the example above, the company’s EPS amount is higher if the company borrows by issuing bonds, but the total net income is higher if the company issues shares.

In some cases, the interest expense may be high enough to eliminate net income from the project.

Accounts Payable Turnover

The accounts payable turnover measures the number of times a year a company is able to pay its accounts payable. Once the turnover is computed, it is usually expressed in number of days, or days payable outstanding (DPO) by dividing 365 by the turnover. The metric varies across industries because different industries have different business models and standard business practices. Generally, a high turnover ratio (short period in days) is better than a low turnover ratio.

$$\text{Accounts Payable (A/P) Turnover} = \frac{\text{Cost of Goods Sold}}{\text{Average A/P}}$$ $$\text{Days Payable Outstanding} = \frac{\text{365}}{\text{A/P Turnover}}$$

The Leverage Ratio

Leverage ratio (also known as the equity multiplier) shows a company’s total assets per dollar of shareholders' equity. A leverage ratio of 1.0 means a company has no debt, because total assets would equal total shareholders' equity. However, this is very rare; most companies have liabilities. Hence, most companies will have leverage ratios greater than 1.0. The lower the leverage ratio, the lower the debt.

$$\text{Leverage Ratio} = \frac{\text{Total Assets}}{\text{Shareholders’ Equity}}$$

The Times-Interest-Earned Ratio

This ratio measures the number of times that operating income can cover interest expense. A high times-interest-earned ratio indicates ease in paying interest expense; a low value suggests difficulty in paying interest.

$$\begin{align*}\text{Times Interest Earned} & = \frac{\text{Operating Income}}{\text{Interest Expense}} \\ \\ & = \frac{\text{Earnings Before Interest and Taxes}}{\text{Interest Expense}} \\ \\ & = \frac{\text{Net Earnings + Interest Expense + Income Tax Expense}}{\text{Interest Expense}}\end{align*}$$