Loan Attractiveness - Debt Metrics, Company Elasticity, Management, FCF Flashcards
What are the 5 C’s of credit?
Character - Credit history Capacity - Debt-to-income ratio, cash flow Collateral - Liquidity of collateral etc Capital - assets Conditions - Macro effects
If you had to invest debt in a company, which kind of company would you choose?
A company with non-cyclical operations (i.e., inelastic goods) and stable free cash flow. A diverse variety of customers, not just one single customer. Strong management. Low amount of existing debt. Adequate, liquid assets to use as collateral. Minimal CapEx requirements. Mature industry and strong competitive advantage.
What is a generally considered a good debt ratio?
Equal to or less than 0.5.
Why are cyclical businesses less desirable to issue debt to?
Cyclical businesses inherently have less debt capacity than non-cyclical businesses. For example, mining businesses are cyclical in nature due to their operations, whereas food businesses are much more stable. From a lender’s point of view, volatile EBITDA represents volatile retained earnings and the ability to repay debt, hence a much higher default risk.
How do barriers to entry affect a company’s debt capacity?
Industries with low barriers to entry also have less debt capacity compared to industries with high barriers to entry. For example, tech companies that have low barriers to entry can easily be disrupted as competition enters. Even if tech companies are legally protected through patents and copyrights, competition will eventually enter as the patent term expires or with newer and more efficient innovations. On the other hand, industries with high barriers to entry, such as long-term infrastructure projects, are less likely to be disrupted by new entrants and, therefore, can sustain a more stable EBITDA.
What does debt-to-EBITDA measure?
The ratio demonstrates a company’s ability to pay off its incurred debt and provides investment bankers with information on the amount of time required to clear all debt, ignoring interest, taxes, depreciation, and amortization. Total debt-to-EBITDA can be broken down into the senior or subordinated debt-to-EBITDA metric, which focuses on debt that a company must repay first in the event of distress.
What does debt-to-equity measure?
Debt to Equity Ratio = Total Debt / Shareholders’ Equity
If, as per the balance sheet, the total debt of a business is worth $50 million and the total equity is worth $120 million, then debt-to-equity is 0.42. This means that for every dollar in equity, the firm has 42 cents in leverage. A ratio of 1 would imply that creditors and investors are on equal footing in the company’s assets.
A higher debt-equity ratio indicates a levered firm, which is quite preferable for a company that is stable with significant cash flow generation, but not preferable when a company is in decline. Conversely, a lower ratio indicates a firm less levered and closer to being fully equity financed. The appropriate debt to equity ratio varies by industry.
What is and isn’t considered debt?
Considered debt:
Drawn line-of-credit Notes payable (maturity within a year) Current portion of Long-Term Debt Notes payable (maturity more than a year) Bonds payable Long-Term Debt Capital lease obligations
Not considered debt:
Accounts payable
Accrued expenses
Deferred revenues
Dividends payable
Why would a high debt-to-equity ratio be considered good? Why would it be bad?
A high debt-equity ratio can be good because it shows that a firm can easily service its debt obligations (through cash flow) and is using the leverage to increase equity returns.
In the example below, we see how using more debt (increasing the debt-equity ratio) increases the company’s return on equity (ROE). By using debt instead of equity, the equity account is smaller and therefore, return on equity is higher.
Another benefit is that typically the cost of debt is lower than the cost of equity, and therefore increasing the D/E ratio (up to a certain point) can lower a firm’s weighted average cost of capital (WACC).
Why is a low WACC better?
The lower a WACC, the cheaper it is for a company to finance projects.
How do you compute WACC?
WACC = [Cost of equity * % equity] + [Cost of debt * % debt * (1-tax rate)]
How do you find the cost of equity, and what is the formula?
Use CAPM.
Cost of Equity = Risk free rate + Beta * (Expected return of the market - risk free rate)
How do you find the cost of debt?
It’s the company’s average cost of debt (interest rate).
What are porter’s five forces?
Threat of new entrants, bargaining power of suppliers, bargaining powers of customers, threat of substitutes, rivalry.
