Analysis of the Funding Structure

The total amount of funding is, as it has to be, the same as the capital employed in the enterprise.

We have seen how to calculate the return on this capital in the previous lesson. What we are interested in now is the way the funding is made up, i.e. what proportion of the funding comes from different sources.

Debt to Total Funding Ratio

Ignoring tax payable, the total funding of a business is the sum of the debt and the equity.

The debt to total funding ratio is thus the debt divided by the total funding, i.e. it shows what percentage of total funding is debt:

Debt to Total Funding = Debt / Total Funding

Debt to Equity Ratio (‘Gearing’)

The debt to total funding ratio shows you at a glance how much of a business is funded by debt and, by deduction, how much by equity.

However, many people prefer to summarize the funding structure in a slightly different way. They divide the debt by the equity and express it as a percentage. This ratio, known as the debt to equity ratio shows how large the debt is relative to the equity.

Debt to Equity Ratio = Debt / Equity

Going back to the example above:

Debt to Equity Ratio = 4,672 / 2,847
= 164%

This tells us that the company’s debt is 1.64 times bigger than its equity.

The debt to equity ratio is probably the more common of the two ratios.

Gearing

Before looking at the shareholders’ perspective, let’s briefly understand the concept of gearing.

We know that gearing is another word for the debt to equity ratio.

It is also used more generally to describe the concept of borrowing money to make an investment. In the US, the word ‘leverage’ is used to mean the same thing.

Debt to Total Funding Ratio

Gearing affects the risk of and potential returns to shareholders. Therefore, shareholders ought to control the level of debt a company takes on but in practice, management tends to decide.

If a company’s debt to tax funding ratio continues to rise over a period of a few years, the shareholders’ risk has risen considerably.

Return on Equity

Shareholders are ultimately interested in the return on the money they have invested i.e. the return on equity – known as ROE.

Since we know a company’s equity, the return is the profit after paying the interest on the loans, i.e. profit before tax.

Return on Equity = Profit before tax / Equity

Average Interest Rate

Companies whose shares are listed on the stock exchange have to tell you what their average interest rates were during the year while private companies do not need to.

For private companies, you can get a rough estimate from the accounts by taking the interest paid during the year and dividing it by the average debt at the start and end of the year.

Average Interest Rate = Interest / Average Debt

Dividend Cover & Payout Ratio

Although ROE measures the return to shareholders for having invested their money in a company over the last year, they do not actually get all this return out of the company in the form of cash.

Remember that profit is not cash. The company is probably still waiting to collect cash from debtors and has manufactured more stock for next year. Some of the profit, however, is paid out in the form of dividends.

Some shareholders rely upon these dividends as a key source of income and they are naturally interested to know how safe the dividends are.

One measure of this is dividend cover which is calculated as profit for the year divided by the dividend.

Dividend Cover = Profit for the year / Dividend for the year

You will sometimes find people using a measure called the payout ratio.

This is simply the inverse of dividend cover expressed as a percentage. It shows what percentage of the profit for the year is paid out as dividends:

Payout Ratio = Dividend / Profit for the year

We can now easily sum up the financial objectives of a company:

A company’s financial objective is to maximize the return it provides on the money invested, based on an appropriate trade-off between the short- and long-term perspectives, while ensuring that the business remains liquid.

What is Liquidity?

Liquidity is the ability of a company to pay its debts as they fall due.

Analyzing a company’s liquidity is quite difficult and there is no single KPI that tells you very much. However, there are two ratios which are commonly used as measures of liquidity which we will cover briefly:

– Current Ratio
– Quick Ratio

Current Ratio

The current ratio is calculated by dividing the current assets by the current liabilities.

The logic behind this is that the current assets should be convertible into cash within one year and the current liabilities are what you have to pay within one year.

Provided your current assets are greater than your current liabilities, you should not have a liquidity problem.

Current Ratio = Current Assets / Current Liabilities

Quick Ratio

The quick ratio is identical to the current ratio except that stock (inventory) is not included in the current assets, on the basis that stock can be hard to sell. All the other assets (principally debtors and cash) are ‘quick’.

How do you assess liquidity?
Ideally, you make week-by-week or month-by-month forecasts of exactly what bills are going to have to be paid when and what customers are going to pay when.

Other than the annual report, it is recommended to look at the cash flow statement for this purpose.