Liquidity and Cash Flow Analysis

There are some practical difficulties with the types of analyses described thus far in the description, including the following.

1. It is virtually impossible to determine exactly how either P/E ratios or equity capitalization rates (k_s values) are affected by different degrees of financial leverage. The best we can do is make educated guesses about these relationships. therefore, management rarely, if ever, has sufficient confidence in the type of analysis set forth in table 13-5 and Figure 13-8 to use it as the sole determinant of the target capital structure.

2. A firm’s managers may be more or less conservative than the average stockholder, hence management may set a somewhat different target capital structure than the one that would maximize the stock price. The managers of a publicly owned firm would never admit this, for unless they owned voting control, they would quickly be removed from office. However, in view of the uncertainties about what constitutes the value-maximizing capital structure, management could always say that the target capital structure employed is, in its judgment, the value-maximizing structure, and it would be difficult to prove otherwise. Still, if management is far off target, especially on the low side then chances are high that some other firm or management group will take the company over, increase its leverage, and thereby raise its value. This point is discussed in more detail.

3. Managers of large firms, especially those which provide vital services such as electricity or telephones, have a responsibility to provide continuous service; therefore, they must refrain from using leverage to the point where the firms’ long-run viability is endangered. Long-run viability may conflict with short-run stock price maximization and capital cost minimization.

For all of these reasons, managers are concerned about the effects of financial leverage on the risk of bankruptcy, so an analysis of potential financial distress is an important input in all capital structure decisions. Accordingly, managements give considerable weight to financial strength indicators such as the times-interest-earned (TIE) ratio. The lower this ratio, the higher the probability that a firm will default on its debt and be forced into bankruptcy.

The tabular material in the lower section of Figure 13-9 shows Bigbee’s expected TIE ratio at several different debt/assets. If the debt/assets ratio were only 10 percent, the expected TIE would be a high 25 times, and the probability of the actual TIE falling below 1.0 would be only 6.4 percent. However, the expected interest coverage ratio would decline rapidly if the debt ratio were increased and the probability of the actual TIE falling below 1.0 would rise, We must stress that the coverage’s shown in the table are the expected values at different debt ratios, and that the actual TIE at any debt ratio would be higher if sales exceeded the expected $200,000 level, but lower if sales fell below $200,000.

Figure 13-9 graphs Bigbee’s probability of default at different levels of debt. In Bigbee’s case, the TIE ratio has a normal distribution, and we used that fact to find the area under the normal curve to the left of 1.0. This number represents the probability that the company will have a TIE ratio less than 1.0 and thus will not be covering its interest expense. We have defined this area to be the probability of default. As you can see from the graph, the chance of default increases as the debt ratio increases.