Debt financing - A case study of AMATA power (BIEN HOA) limited : Luận văn thạc sĩ

MINISTRY OF EDUCATION AND TRAINING
UNIVERSITY OF ECNOMICS HOCHIMINH CITY
---- K ---

NGUYEN THI THANH THAO

DEBR FINANCING – A CASE STUDY Ò
AMATA POWER (BIEN HOA) LIMITED

MASTES’S THESIS
In Banking
Ology code: 60.31.12

Supervisor: Dr.TRUONG TAN THANH

Ho Chi Minh City – 2010


ACKNOWLEDGEMENT
The research is completed due to the contribution of many people. First of
all, I would like to express my deepest gratitude to my supervisor, Dr. Truong Tan
Thanh, for all he has done for me. The thesis could not been finished without his
great encouragements and kind helps. Again, I would like to extend my sincere
appreciation to him.
I would like to express my thanks to Dr. Nguyen Minh Kieu for his valuable
advices. He always took care, encouraged and supported us during our course.
I acknowledge all instructors at Faculty of Banking Finance and
Postgraduate Faculty, University of Economics of Ho Chi Minh for their valuable
knowledge.
My gratitude is extended to my classmates for their enthusiastic supports in
conducting the research, especially Ms. Nguyen Thi Kim Dung and Mr. Duong

Binh Hung.
Finally, I sincerely thank my parents and my husband who have always tried
their best to help me overcome difficulties during the time of attending the course as
well as preparing the thesis.

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ABSTRACT
The economy has been developing more and more strongly, the competition
among firms is fiercer and fiercer. In order to run the firm’s business operation in
the competitive market, capital is one of necessary elements to speed up the
development. It likes the blood of the firm. There are three financing alternatives to
set up the capital which are retained earnings, capital from shareholders and loans
from credit institutions. The choice of internal or external financing is an extremely
vital decision. Some of firms like the internal financing (retained earnings, capital
from shareholders) due to avoiding the financial risks. Some of firms prefer the
external financing (loans from credit institutions) due to taking advantages of tax
shield and controlling management position. However, too much debt can result in
increasing dramatically capital costs due to financial distress in terms of increased
bankruptcy and agency costs. So, the careful consideration to the advantages and
disadvantages of each financing resource should be conducted to balance between
returns and risks. And financial analysis should be done in order to minimize
financial risks in case of debt financing.
The purpose of this thesis is to evaluate the effectiveness of debt financing
process of a defined firm, Amata Power (Bien Hoa) Limited. The research is
conducted by collecting and analyzing the empirical data in order to understand
debt repayment ability as well as the impacts of debt on expenses and profits.

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TABLE OF CONTENTS
Acknowledgement ................................................................................................. 1
Abstract .................................................................................................................. 2
Table of contents ................................................................................................... 3
Abbreviation .......................................................................................................... 6
List of figures ......................................................................................................... 7
List of tables ........................................................................................................... 8
Chapter 1: Introduction ....................................................................................... 9
1.1 Introduction ................................................................................................. 9
1.2 Research problem ...................................................................................... 10
1.3 Methodology .............................................................................................. 11
1.4 Significance and scope of the study .......................................................... 11
1.5 Structure of the study ................................................................................. 12
Chapter 2: Theoretical background .................................................................. 14
2.1 Introduction ............................................................................................... 14
2.1.1 The Miller and Modigliani theory ..................................................... 14
2.1.2 The trade-off theory .......................................................................... 17
2.1.3 The pecking order theory (Myers, 1984) .......................................... 18
2.2 An overview of debt financing .................................................................. 19
2.3 Financial ability to repay debt ................................................................... 21
2.4 Financial risks of debt financing in a foreign currency ............................. 27
2.4.1 Interest rate risk ................................................................................. 27
2.4.2 Foreign exchange risk ....................................................................... 27
2.5 Conclusion ................................................................................................. 28
Chapter 3: Research methodology .................................................................... 29
3.1 Introduction ............................................................................................... 29
3.2 Analysis of debt settlement ability ............................................................ 29
3.2.1 Liquidity ............................................................................................ 29

3.2.2 Activity .............................................................................................. 30

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3.2.3 Debt management ratios .................................................................... 30
3.2.4 Earnings ratios ................................................................................... 31
3.2.5 Profitability measurement ratios ....................................................... 31
3.3 Analysis on financial risks of debt financing in a foreign currency .......... 34
3.3.1 Interest rate risk ................................................................................ 34
3.3.2 Foreign exchange risk ....................................................................... 34
3.4 Impacts of debt financing on profit ........................................................... 34
3.5 Conclusion ................................................................................................. 35
Chapter 4: Introduction to Amata Power (Bien Hoa) Limited ...................... 37
4.1 An overview of Amata Power (Bien Hoa) Limited ................................... 37
4.2 Financial performance ............................................................................... 38
4.2.1 Capital structure ................................................................................ 38
4.2.2 Business operation ............................................................................ 39
4.2.3 Profitability measurement ................................................................. 41
4.2.4 Debt management policy .................................................................. 43
4.3 Recent development and outlook .............................................................. 43
Chapter 5: Analysis on debt financing of Amata Power (Bien Hoa) Ltd. ..... 45
5.1 Introduction ............................................................................................... 45
5.2 An overview of debt financing of APBH .................................................. 45
5.2.1 Short-term borrowings ...................................................................... 45
5.2.2 Long-term borrowings ...................................................................... 45
5.3 Analysis on debt settlement ability ............................................................ 48
5.3.1 Debt settlement ability ...................................................................... 48
5.3.2 Debt control method .......................................................................... 50
5.3.3 Method of cash flow management ................................................... 52

5.4 Analysis on debt impacts ........................................................................... 55
5.4.1 Impact of debt on expenses ............................................................... 55
5.4.2 Risks related to debt in a foreign currency ....................................... 57
5.4.2.1 Foreign exchange risk ............................................................... 57

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5.4.2.2 Interest rate risk ........................................................................ 60
5.4.3 Impact of debt on profits ................................................................... 61
5.5 Conclusions ............................................................................................... 65
Chapter 6: Research conclusion ........................................................................ 66
6.1 Summary of study ...................................................................................... 66
6.2 Implications and recommendations ........................................................... 67
6.3 Future research and limitations .................................................................. 69
Bibliography ........................................................................................................ 70

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ABBREVIATION
APBH

Amata Power (Bien Hoa) Limited

AP

Amata Power Limited

Amata VN

Amata Viet Nam Joint Stock Company

BP

Banpu Public Company Limited

BIDV

Bank for Investment and Development of Vietnam

DEG

Deutsche Investitions - Und Entwicklungsgesellschaft MBH

EBIT

Earnings before interest and tax

KfW

Kreditanstalt fur Wiederaufbau

ROA

Return on assets

ROE

Return on equity

ROIC

Return on invested capital

ROS

Return on sales

TIE ratio

Times-Interest-Earned ratio

VCB

Bank for Foreign Trade of Vietnam (Vietcombank)

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LIST OF FIGURES
Figure 2.1: Effect of leverage on the value of a firm’s stock.................................... 18
Figure 2.2: Liquidity analysis .................................................................................. 25
Figure 2.3: Analysis on debt repayment ability ....................................................... 26
Figure 4.1: Structure of shareholders of APBH as of December 31, 2009 .............. 39
Figure 4.2: Growth of assets and resources of APBH from 2005 to 2009 .............. 40
Figure 4.3: Growth of revenue and profit/loss of APBH from 2005 to 2009 .......... 41
Figure 4.4: Profitability ratios of APBH from 2002 to 2009 ................................... 41
Figure 4.5: Profitability of APBH from 2004 to 2009 ............................................. 42
Figure 5.1: Liquidity ratios of APBH from 2002 to 2009 ....................................... 48

Figure 5.2: Growth of current assets and current liabilities ..................................... 50
Figure 5.3: Debt management ratios of APBH from 2002 to 2009 ......................... 51
Figure 5.4: Earnings coverage ratios of APBH from 2002 to 2009 ......................... 52
Figure 5.5: Cash conversion cycle of APBH from 2002 to 2009 ............................ 53
Figure 5.6: The cash conversion cycle model in 2009 ............................................. 54
Figure 5.7: Assets – equity turnover of APBH from 2002 to 2009 ......................... 55
Figure 5.8: Financial expenses of APBH from 2008 to 2010 .................................. 56
Figure 5.9: Impact of debt on expenses of APBH from 2002 to 2009 .................... 57
Figure 5.10: Interest rate risk of APBH from 2005 to 2009 .................................... 60

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LIST OF TABLES
Table 2.1: Summary of financial ratios from the lending viewpoint ....................... 22
Table 2.2: Summary of financial ratios from the investors’ viewpoint ................... 23
Table 2.3: Financial ratios combining ratio analysis with cash-flow analysis ........ 24
Table 2.4: Foreign exchange risk of Pha Lai Thermal Power JSC .......................... 28
Table 3.1: Financial analysis of APBH from 2002 to 2009 ..................................... 33
Table 4.1: Capital Structure of APBH as of December 31, 2009 ............................ 39
Table 4.2: Growth of assets and resources of APBH from 2005 to 2009 ................ 40
Table 4.3: Growth of revenue and profit/loss of APBH from 2005 to 2009 ........... 40
Table 4.4: Profitability ratios of APBH from 2002 to 2009 .................................... 41
Table 4.5: Comparison ROE and free-risk interest rate ........................................... 42
Table 5.1: Loan disbursement and repayment schedule of APBH .......................... 47
Table 5.2: Liquidity ratios of APBH from 2002 to 2009 ......................................... 48
Table 5.3: Growth of current assets and current liabilities ...................................... 50
Table 5.4: Debt management ratios of APBH from 2002 to 2009 .......................... 50
Table 5.5: Earnings coverage ratios of APBH from 2002 to 2009 .......................... 51
Table 5.6: Activity ratios of APBH from 2002 to 2009 .......................................... 52

Table 5.7: Assets – equity turnover ratios of APBH from 2002 to 2009 ................. 55
Table 5.8: Costs structure of APBH from 2008 to 2010 .......................................... 56
Table 5.9: Impact of debt on expenses of APBH from 2002 to 2009 ...................... 57
Table 5.10: Foreign exchange rate (USD/VND) on settlement date to creditors .... 59
Table 5.11: Interest rate of creditors and two banks in Vietnam ............................. 60
Table 5.12: Comparison with firm in the same industry in 2009 ............................ 62
Table 5.13: Components of return on equity for APBH .......................................... 62
Table 5.14: Extended Dupont System Analysis for APBH: 2002-2009 .................. 63

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CHAPTER 1
INTRODUCTION
1.1 INTRODUCTION
The globalization has brought countries together and made countries
integrate deeply into the world. Nowadays the economic competitiveness does not
limit in the national border, it has extended to the international market. The capital
is means to create favourable conditions for the successful business. Most firms
prefer the capital mobilization from debt. There are many kinds of debt which are
bank loans, sponsor loans, bonds, and account payable.
In comparison with equity, debt is cheaper and has more tax advantages. In
the upturn, using leverage helps companies to maximize their profit. But in the
downturn, the debt management becomes more difficult. Facing with huge debts,
only a little downtrend can lead to insolvency. Borrowing to run business is not
wrong, but too much debt is problematic.
Brigham and Ehrhardt (2002, p.619) also indicated that debt has two
important advantages. First, the interest paid is a tax deduction, which lowers debt’s
effective cost. Second, debt holders get a fixed return, so stockholders do not have
to share the profits if the business is extremely successful. However, debt also has

disadvantages as following: First of all, the higher the debt ratio, the riskier the
company, hence the higher its cost of both debt and equity. Secondly, if a company
falls on hard times and operating income is not sufficient to cover interest charges,
its stockholders will have to make up the shortfall, and if they cannot, bankruptcy
will result.
In this thesis, debt financing in form of loans from credit institutions and
parent companies is mainly discussed. In order to get bank loans and sponsor loans,
the company needs to demonstrate its financial solidity to its bankers by the
financial analysis. The goal of analysis is to assess an obligor from a financial

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perspective to confirm that company will be able to meet its obligations when they
are due, to identify the potential risks, and to perfect the security and collateral and
loan documentations in order to optimally manage these inherent risks. (Andrew
Fight, 2004, p.104).
Besides financial analysis is a tool which is used to evaluate company’s
business operation which is volatile or stable in order to define the level of debt
financing.

1.2 RESEARCH PROBLEM
Amata Power (Bien Hoa) Ltd. (named briefly as APBH) is a joint-venture
company of which the capital comes from Thai, Swiss and Vietnamese parties.
APBH has produced and supplied power to all customers in Amata industrial park.
APBH’s capital is made up of contributed capital from shareholders and debts in
form of bank loans and sponsor loans from other foreign companies.
APBH is a suitable choice to conduct this study. Because one of factors
influencing debt financing in form of bank loans is ability to receive bank loans,
APBH is a manufacturing company which has many fixed assets that can serve as

securities for bank loans. Besides APBH obtains loan guarantees from the parent
company, Amata Power Limited in Thailand. APBH has high sale stability because
it does business in monopoly sector.
Determining the optimal amount of debt is a complicated process. Many
researches in this area are conducted, but yet there is no optimal combination of
debt and equity for firms to apply. This study makes no effort in trying to solve this
issue, but it will discuss some specific research questions as follows:
• How good are the firm’s financial abilities to settle debt?
• How does debt financing impact on profit?
The purpose of this study is to evaluate financial abilities of the firm to meet
its short- and long-term debt obligations and the effects of debt on profit in order to
assess the effectiveness of debt financing process.

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1.3 METHODOLOGY
A case study is conducted at APBH by the quantitative approach. The
secondary data is retrieved from annual auditing reports and loan dossier of the
firm. The data is collected from Y2002 to Y2009.

1.4 SIGNIFICANCE AND SCOPE OF THE STUDY
Efficient debt management is an extremely difficult problem. It requires the
leaders have talent management skills and exact estimations. One of recent typical
examples for bad debt management is the Vinashin case. “Vinashin fell into
financial trouble in 2008 when the global economic meltdown started. The main
reason was the weak management of group’s leaders. Currently, Vinashin’s total
debts are $4.5 billion, while total assets are $5.4 billion”. (Ninh Kieu, 2010, p.3). To
help Vinashin avoid bankruptcy, the government has a restructuring plan and
provides an initial $131.5 million financial bailout to complete unfinished

shipbuilding projects. (Nhu Ngoc, 2010). First of all, the government has
restructured the group’s board, and then forced Vinashin to focus on core businesses
like shipbuilding, ship-repairing and shipbuilding-related industries. The lesson of
Vinashin indicates that borrowing is a small issue, but how to manage debt
efficiently is a complex problem.
APBH is a joint venture company. Its capital is not only equity from
shareholders but also debt from foreign banks. It is a typical firm with high debt
ratio, but the efficiency of debt financing has not been evaluated properly, no one
has evaluated it before. The purpose of this study is to evaluate the efficiency of
debt financing of the company in order to have the right decision on capital in the
future when starting a new project.
Due to a specific case study, the research results from case analysis may not
be generalized and applied to all other firms. Ratios should be compared with the
aggregate economy, its industry or industries, its major or competitors within the
industry.

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1.5 STRUCTURE OF THE STUDY
Chapter 1: Introduction to the study
This chapter gives an overview of the study. Firstly, it begins with an
introduction to research background. Secondly, it explains more research problem
through research questions and research objectives. Thirdly, it makes clear
applicable research method to the study. Fourthly, it presents the reasons why the
subject is chosen and its limitation. Finally, it ends with the outline of study.
Chapter 2: Theoretical background
This chapter will present theoretical framework relating to debt financing. It
consists of five sections. The first section begins with the outline of the chapter and
reviews three previous capital structure theories which are the Miller and

Modigliani theory, the trade-off theory, the pecking order theory. The second
section introduces an overview of debt financing and some factors influencing the
debt financing decision. The third section discusses a firm’s financial ability to meet
its short- and long-term obligations. The fourth section analyzes the importance of
financial risks relating to debt financing in a foreign currency such as interest rate
risk and foreign exchange risk. The fifth section provides some conclusions to this
chapter.
Chapter 3: Research methodology
This chapter discusses the research methodology which has been used to test
hypotheses. It includes five parts. The first part introduces structure of the chapter.
The second part presents the method for analyzing the financial ability to repay
debt. The third part focuses on the ways to determine financial risks of debt
financing in a foreign currency. The fourth part clarifies impacts of debt financing
on profits. The last part ends with some conclusions.
Chapter 4: Introduction to Amata Power (Bien Hoa) Limited
This chapter provides an overview of Amata Power (Bien Hoa) Ltd. from the
beginning of establishing the firm until now. The first section explains the reasons
why Amata Power (Bien Hoa) Ltd. is set up and located at Amata industrial park as

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well as the development phases of power plant. The second section summarizes
some main points of finance. The third section introduces the developments of
power plant in the near future.
Chapter 5: Analysis on debt financing of Amata Power (Bien Hoa) Limited
This chapter focuses on applying the theory to make clear two research
questions. It includes five sections. The first section introduces the outline of the
chapter. The second section summarizes an overview of debt financing of APBH.
The third section presents debt repayment ability of APBH. The fourth section

analyses the impacts of debt on expenses and profits. The last section draws some
findings from the practical analysis.
Chapter 6: Research Conclusion
This chapter will draw conclusions from the data analysis, recommendations
as well as the limitation of the study. The first section summarizes the conclusion of
the research. The second section presents the implication of the study and some
recommendations. The last section ends with the limitation of the study.

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CHAPTER 2
THEORETICAL BACKGROUND
2.1 INTRODUCTION
This chapter will present theoretical framework relating to debt financing. It
consists of five sections. The first section begins with the outline of the chapter and
reviews three previous capital structure theories which are the Miller and
Modigliani theory, the trade-off theory, the pecking order theory. The second
section introduces an overview of debt financing and some factors influencing the
debt financing decision. The third section discusses a firm’s financial ability to meet
its short- and long-term obligations. The fourth section analyzes the importance of
financial risks relating to debt financing in a foreign currency such as interest rate
risk and foreign exchange risk. The fifth section provides some conclusions to this
chapter.
Capital structure is a financial complex issue and causes many debates.
Franco Modigliani and Merton Miller presented their theory on capital structure as
an original generally accepted theory. Although the Miller and Modigliani theories
with a number of non-realistic assumptions do not provide a realistic description of
how firms should set up their capital structure, it is a theoretical framework to
evolvement of later theories which are the trade-off theory and the pecking order

theory.
2.1.1 The Miller and Modigliani Theory
Brigham and Ehrhardt (2002, p.642) emphasized the Miller and Modigliani
theory as a modern capital structure theory.
In 1958, Franco Modigliani and Merton Miller published a financial article
in which a firm’s value is unaffected by its capital structure with a number of
assumptions as follows: (1) There are no brokerage costs. (2) There are no taxes. (3)
There are no bankruptcy costs. (4) Investors can borrow at the same rate as

14


corporations. (5) All investors have the same information as management about the
firm’s future investment opportunities. (6) EBIT is not affected by the use of debt.
In 1963, Franco Modigliani and Merton Miller published a follow-up article
in which they relaxed the assumption that there are no corporate taxes. Interest
payments are deductible as the expenses, but dividend payments to shareholders are
not deductible. This conclusion encourages firms to use a high level of debt
financing due to the benefits of attracting a tax shield.
Several years later, Merton Miller modified their theory that returns on
stocks are taxed at lower effective rates than returns on debt in accordance with the
effects of personal taxes. That leads to favor the use of equity financing.
Ross, Westerfield and Jaffe (2005, p.418, 426) summarized the Miller and
Modigliani theory as follows:
Summary of Modigliani-Miller Propositions without Taxes
Assumptions
• No taxes
• No transaction costs
• Individuals and corporations borrow at the same rate
Results

Proposition I: VL = VU (Value of levered firm equals value of unlevered firm)
Proposition II: rS = r0 + (B / S) (r0 – rB)
Intuition
Proposition I: Through homemade leverage, individuals can either duplicate or undo
the effects of corporate leverage.
Proposition II: The cost of equity rises with leverage, because the risk to equity rises
with leverage.

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Homemade leverage means if levered firm are priced too high, rational investors
will simply borrow on their personal accounts to buy shares in unlevered firms.
Where
VL is the value of levered firm
VU is the value of unlevered firm
rS

is the expected return on equity or stock, also callled the cost of equity or
the required return on equity

rB

is the interest rate, also called the cost of debt

r0

is the cost of capital for an all-equity firm

B

is the value of the firm’s debt or bonds

S

is the value of the firm’s stock or equity
Summary of Modigliani-Miller Propositions with Corporate Taxes

Assumptions
• Corporations are taxed at the rate TC on earnings after interest.
• No transaction costs
• Individuals and corporations borrow at the same rate
Results
Proposition I: VL = VU + TC x B (for a firm with perpetual debt)
Proposition II: rS = r0 + (B / S) (1 – TC) (r0 – rB)
Intuition
Proposition I: Since corporations can deduct interest payments but not dividend
payments, corporate leverage lowers tax payments.
Proposition II: The cost of equity rises with leverage, because the risk to equity rises
with leverage.

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2.1.2 The Trade-Off Theory
Brigham and Ehrhardt (2002, p.644) stated that in practice bankruptcy can be
quite costly. Firms in bankruptcy have very high legal and accounting expenses, and
they also have a hard time retaining customers, suppliers, and employees.
Moreover, bankruptcy often forces a firm to liquidate or sell assets for less than they
would be worth if the firm were to continue operating.

Bankruptcy-related problems are most likely arisen when a firm includes a
great deal of debt in its capital structure. Therefore, bankruptcy costs discourage
firms from pushing their use of debt to excessive level.
The preceding arguments led to the development of what is called “the tradeoff theory of leverage” in which firms trade off the benefits of debt financing
(favorable corporate tax treatment) against the higher interest rates and bankruptcy
cost.
The trade-off theory presents the optimal capital structure in which marginal
tax shelter benefits equal to marginal bankruptcy-related costs through the use of
debt financing.

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Figure 2.1: Effect of leverage on the value of a firm’s stock
Value of
stock

MM Result incorporating the Effects of
Corporate Taxation: Price of the stock if
there were no bankruptcy-related costs
Value reduced by
bankruptcy-related costs

Value added by debt
tax shelter benefits

Actual price of stock

Value of stock if
the firm used no

financial leverage

0

D1

Threshold debt level
where bankruptcy
costs become material

D2

Leverage, D/A

Optimal capital structure:
Marginal tax shelter benefits =
Marginal bankruptcy-related costs

Source: Financial management, Brigham, E.F. and Ehrhardt M.C. (2002)

2.1.3 The Pecking Order Theory (Myers, 1984)
The pecking order theory is from Myers (1984). It states that if a firm issues
equity, investors will infer that the stock is overvalued. They will not buy it until the
stock price has fallen enough to eliminate any disadvantage from equity issuance.
The result is that no one will issue equity.
Suppose there are three sources of funding available to firms: retained
earnings, debt, and equity. Retained earnings have no any adverse selection
problem, equity is subject to serious adverse selection problem while debt has only

18

a minor adverse selection problem. From that point of view, equity is strictly riskier
than debt. The theory states that the firms prefer internal resources to external
resources. First, the firms choose retained earnings from previous years to finance
their projects. Second, if firms do not possess enough internal capital, they will take
loans from credit institutions. Third, if firms do not have enough ability to receive a
bank loan, they will issue new shares. Benefits of internal financing are cheaper
transactions costs and maintaining the shareholders’ control of their business.
There are two rules of the pecking order:
• Rule 1: Use internal financing.
• Rule 2: Issue the safest securities first.

2.2 AN OVERVIEW OF DEBT FINANCING
Debt financing is defined that is financing a company by selling the bonds,
notes or mortgages held by the business. Basically it is borrowing money to keep
the business running. Long term debt financing is typically associated with larger
assets such as buildings, equipments, land, and large machinery. The schedule for
repayment for long term debt financing spends for more than a year. Short term debt
financing is mostly associated with operations of the business such as inventory
purchasing, payroll, and supplies. The repayment of short term debt financing
happens in less than a year. With debt financing, the business does not have to give
up future profits or ownership in the company like with equity financing [1].
Ross, Westerfield and Jaffe (2005) referred debt financing in terms of benefit
from the viewpoints of owners as well as creditors, and emphasized that financial
leverage is related to the extent to which a firm that relies on debt financing rather
than equity. There are three implications of debt financing: (1) By raising funds
through debt, stockholders can maintain control of a firm without increasing their
investment. (2) Creditors look to the equity, or owner-supplied funds, to provide a
margin of safety, so the higher the proportion of total capital provided by

stockholders, the less the risk faced by creditors. (3) If the firm earns more on
[1]

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investments financed with borrowed funds than it pays in interest, the return of the
owners’ capital is magnified, or “leveraged”.
The use of debt “leverages up” the expected rate of return on equity in
normal conditions. There are two reasons for the leveraging effect: (1) Because
interest is a deductible expense, the use of debt lowers the tax bill and leaves more
of the firm’s operating income available to its investors. (2) If operating income as a
percentage of assets exceeds the interest rate on debt, as it generally does, then firm
can use debt to acquire assets, pay the interest on the debt, and have something left
over as a “bonus” for its stockholders. However, financial leverage can cut both
ways in recessions. If sales are lower and costs are higher than were expected, the
return on assets will also be lower than was expected. The leveraged firm’s return
on equity falls especially sharply, and losses occur. (Brigham and Ehrhardt, 2002,
p.82). To use debt effectively, firms consider balancing higher expected returns
against increased risks.
There are twelve factors influencing the debt financing decisions as follows
(Brigham and Ehrhardt, 2002):
• Sales Stability - A firm whose sales are relatively stable can safely take on
more debt and incur higher fixed charges than a company with unstable
sales.
• Asset Structure - Firms whose assets are suitable as security for loans tend
to use debt rather heavily.
• Operating Leverage - A firm with less operating leverage is better able to
employ financial leverage because it will have less business risk.

• Growth Rate - Other things the same, faster-growing firms must rely more
heavily on external capital. However, firms often face greater uncertainty,
which tends to reduce their willingness to use debt.
• Profitability - The high rates of return enable firms to do most of their
financing with internally generated funds.

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• Taxes - A major reason for using debt is that interest is deductible, which
lowers the effective cost of debt. However, if most of a firm’s income is
already sheltered from taxes by depreciation tax shields, by interest on
currently outstanding debt, or by tax loss carry-forwards, its tax rate will be
low, so additional debt will not be as advantageous as it would be to firm
with higher effective tax rate.
• Control - The effect of debt versus stock on a management’s control
position can influence capital structure.
• Management Attitudes - Some aggressive managers have a tendency to use
debt in an effort to boost profits, whereas managers tend to be more
conservative than others, and thus use less debt than average firm in their
industry.
• Lender and Rating Agency Attitudes - Regardless of managers’ own
analyses of the proper leverage factors for their firms, lenders’ and rating
agencies’ attitudes frequently influence debt financing decisions.
• Market Conditions - Conditions in the stock and bond markets undergo
both long- and short-run changes that can have an important bearing on a
firm’s optimal capital structure.
• The Firm’s Internal Condition - A firm’s own internal condition can also
have a bearing on its target capital structure due to information asymmetry.
• Financial Flexibility - Financial flexibility is the ability to raise capital on

reasonable terms under adverse conditions.

2.3 FINANCIAL ABILITY TO REPAY DEBT
From the bankers’ and investors’ viewpoint, Andrew Fight (2004) conducted
study of the debt financing through ratio analysis. The goal of analysis is to evaluate
a firm’s financial abilities to meet its obligations as well as identify the potential
risks. There is no “standard set” of ratios. It depends on the nature of the firm and
what risks the firm may be facing.

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Although the reputation of ratio analysis is a retrospective diagnostic system,
it has also evolved and also has its uses. It is useful in analyzing trends by
comparing year on year statistics. It can help form an overall picture of the firm’s
situation. It can provide useful clues as to the state of a company’s health. It can
help in assessing a firm’s profitability and financial structure. It can assist in
perfecting security arrangements to enhance the lending bank’s ability to manage
the loan and call in the loan for repayment.
From the lending viewpoint, there are four categories of financial ratios in
order to making loan granting decisions, such as liquidity management ratios, asset
management ratios, capital structure ratios, and profitability ratios.
Table 2.1: Summary of financial ratios from the lending viewpoint
Categories of ratios

Meaning of ratios

1. Liquidity measurement ratios
Current ratio

To assess ability to meet its short-term obligations

Quick ratio

To evaluate ability to pay firm’s debt at short notice

2. Asset management ratios
Debtors to sales

To indicate the period of credit given to customers

Stock turnover

To compare cost of goods sold with the investment in stock

3. Capital structure ratios
To assess the relationship between the borrowings and the

Gearing ratio

equity
To evaluate the margin of profitability to meet the interest

Interest cover

repayments on debt

Dividend cover

To compare profits generated and dividend payable

4. Profitability measurement ratios
To show the management’s use of the resources under its

Profit margin

control

Return on capital employed

To identify amount the firm is earning on the capital that is
invested in it

Source: Credit risk management, Andrew Fight (2004)

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From the investors’ viewpoint, there are three groups of financial ratios to
measure the performance of the firm, its financial standing, and return on
investment.
Table 2.2: Summary of financial ratios from the investors’ viewpoint
1. Performance ratios - to measure how well a firm is controlling expenses and managing assets to
produce sales and profit
•

Profitability performance measurements: return on capital employed, return on equity,
profit margin

•

Asset performance measurements: net asset turnover, fixed asset turnover, working capital
ratio, stock turnover, debtor turnover, creditor turnover

2. Financial standing ratios – to examine levels of debt in relation to both assets and other equity
as well as ability to repay debt
•

Short-term liquidity measurements: current ratio, quick ratio

•

Long-term solvency measurement: gearing ratio, interest cover ratio

3. Investment ratios – to measure the performance of the investment and to assess the likely future
performance
•

Dividend cover

•

Earnings per share (EPS)

•

Price/earnings (P/E) ratio
Source: Credit risk management, Andrew Fight (2004)

Besides the benefits of ratio analysis, Andrew Fight (2004) also pointed out its

limitations as follows:
• Publicly available information is often not sufficiently detailed and out of
date.
• Each firm may have adopted different accounting policies and adjustments.
• It is very difficult to establish the performance of any one firm within the
group through consolidated accounts.
• The figures stated in the accounts may be untypical for the rest of the year.
• “Window dressing” the balance sheet at year end is not uncommon.

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• There should always be a logical relationship between the numerator and the
denominator, which should both be measured consistently and on the same
basis as any comparative ratio.
• The possible effects of inflation and general economic conditions tend to be
cyclical in comparing ratios over time.
• When comparing one firm’s ratios to another’s, the second firm should be
similar both in terms of the industry sector, size and technology.
• A ratio should always be interpreted in the full context of the firm’s affairs.
To minimize the above limitations, Reilly and Brown (2006) conducted ratio
analysis in combination with cash-flow analysis to assess the debt repayment and
financial risks relating to the firm.
Table 2.3: Financial ratios combining ratio analysis with cash-flow analysis
1. Internal liquidity ratios: current ratio, quick ratio, cash ratio, receivables turnover, inventory
turnover, payables turnover
2. Operating performance
•

Operating efficiency ratios: total asset turnover, net fixed asset turnover, equity turnover

•

Operating profitability ratios: profit margin, return on total invested capital, return on
equity

3. Proportion of debt (balance sheet ratio) – indicate what proportion of the firm’s capital is
derived from debt compared to other sources of capital
•

Debt - equity ratio

•

Long-term debt - total capital ratio

•

Total debt – total capital ratio

4. Earnings and cash flow coverage ratios – indicate the flow of earnings or cash flows available to
meet the required interest and lease payments; and cash flow to a firm’s outstanding debt.
•

Interest coverage ratio

•

Fixed financial cost coverage

•

Cash flow coverage ratio

•

Cash flow – long-term debt ratio

•

Cash flow – total debt ratio

Source: Investment analysis and portfolio management, Frank K. Reilly and Keith C.Brown (2006)

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