Recently Standard and Poor’s changed the debt rating of General Motors and Ford
ID: 2762925 • Letter: R
Question
Recently Standard and Poor’s changed the debt rating of General Motors and Ford Motor from investment grade to junk bond status. This will prevent many institutions such as banks, insurance companies, pension plans, etc. from owning their debt. As a result, it will also significantly increase these corporations’ costs of borrowing. Research the 10-K’s of each company.
Discuss what financial ratios and other factors you would consider as a creditor before extending credit to a borrower with significant debt (such as GM).
Explanation / Answer
Solution:
The Financial ratios are one of the most common tools of managerial decision making. A ratio is a comparison of one number to another mathematically, a simple division problem. Financial ratios involve the comparison of various figures from the financial statements in order to gain information about a company's performance.
Different ratios to be considered are :
PROFITABILITY RATIOS
Perhaps the type of ratios most often used and considered by those outside a firm are the profitability ratios. Profitability ratios provide measures of profit performance that serve to evaluate the periodic financial success of a firm. One of the most widely-used financial ratios is net profit margin, also known as return on sales.
Return on sales provides a measure of bottom-line profitability. For example, a net profit margin of 6 percent means that for every dollar in sales, the firm generated six cents in net income.
Two other margin measures are gross profit margin and operating margin.
Gross margin measures the direct production costs of the firm. A gross profit margin of 30 percent would indicate that for each dollar in sales, the firm spent seventy cents in direct costs to produce the good or service that the firm sold.
Return on assets (ROA)
It measures how effectively the firm's assets are used to generate profits net of expenses. An ROA of 7 percent would mean that for each dollar in assets, the firm generated seven cents in profits. This is an extremely useful measure of comparison among firms's competitive performance, for it is the job of managers to utilize the assets of the firm to produce profits.
Return on equity (ROE)
It measures the net return per dollar invested in the firm by the owners, the common shareholders. An ROE of 11 percent means the firm is generating an 11-cent return per dollar of net worth.
One should note that in each of the profitability ratios mentioned above, the numerator in the ratio comes from the firm's income statement. Hence, these are measures of periodic performance, covering the specific period reported in the firm's income statement. Therefore, the proper interpretation for a profitability ratio such as an ROA of 11 percent would be that, over the specific period (such as fiscal year 2004), the firm returned eleven cents on each dollar of asset investment.
ASSET UTILIZATION RATIOS
Asset utilization ratios provide measures of management effectiveness. These ratios serve as a guide to critical factors concerning the use of the firm's assets, inventory, and accounts receivable collections in day-to-day operations. Asset utilization ratios are especially important for internal monitoring concerning performance over multiple periods, serving as warning signals or benchmarks from which meaningful conclusions may be reached on operational issues. An example is the total asset turnover (TAT) ratio.
This ratio offers managers a measure of how well the firm is utilizing its assets in order to generate sales revenue. An increasing TAT would be an indication that the firm is using its assets more productively. For example, if the TAT for 2003 was 2.2×, and for 2004 3×, the interpretation would follow that in 2004, the firm generated $3 in sales for each dollar of assets, an additional 80 cents in sales per dollar of asset investment over the previous year. Such change may be an indication of increased managerial effectiveness.
LEVERAGE RATIOS
Leverage ratios, also known as capitalization ratios, provide measures of the firm's use of debt financing. These are extremely important for potential creditors, who are concerned with the firm's ability to generate the cash flow necessary to make interest payments on outstanding debt. Thus, these ratios are used extensively by analysts outside the firm to make decisions concerning the provision of new credit or the extension of existing credit arrangements. It is also important for management to monitor the firm's use of debt financing. The commitment to service outstanding debt is a fixed cost to a firm, resulting in decreased flexibility and higher break-even production rates. Therefore, the use of debt financing increases the risk associated with the firm. Managers and creditors must constantly monitor the trade-off between the additional risk that comes with borrowing money and the increased opportunities that the new capital provides. Leverage ratios provide a means of such monitoring.
The total debt of a firm consists of both long- and short-term liabilities. Short-term (or current) liabilities are often a necessary part of daily operations and may fluctuate regularly depending on factors such as seasonal sales. Many creditors prefer to focus their attention on the firm's use of long-term debt. Thus, a common variation on the total debt ratio is the long-term debt ratio, which does not incorporate current liabilities in the numerator.
Similarly, the fixed charge coverage ratio, also known as the debt service coverage ratio, takes into account all regular periodic obligations of the firm.
LIQUIDITY RATIOS
Managers and creditors must closely monitor the firm's ability to meet short-term obligations. The liquidity ratios are measures that indicate a firm's ability to repay short-term debt. Current liabilities represent obligations that are typically due in one year or less. The current and quick ratios are used to gauge a firm's liquidity.
A current ratio of 1.5× indicates that for every dollar in current liabilities, the firm has $1.50 in current assets. Such assets could, theoretically, be sold and the proceeds used to satisfy the liabilities if the firm ran short of cash. However, some current assets are more liquid than others. Obviously, the most liquid current asset is cash. Accounts receivable are usually collected within one to three months, but this varies by firm and industry. The least liquid of current assets is often inventory. Depending on the type of industry or product, some inventory has no ready market. Since the economic definition of liquidity is the ability to turn an asset into cash at or near fair market value, inventory that is not easily sold will not be helpful in meeting short-term obligations. The quick (or acid test) ratio incorporates this concern.
By excluding inventories, the quick ratio is a more strident liquidity measure than the current ratio. It is a more appropriate measure for industries that involve long product production cycles, such as in manufacturing.
MARKET VALUE RATIOS
Managers and investors are interested in market ratios, which are used in valuing the firm's stock. The price-earnings ratio and the market-to-book value ratio are often used in valuation analysis. The price/earnings ratio, universally known as the PE ratio, is one of the most heavily-quoted statistics concerning a firm's common stock. It is reported in the financial pages of newspapers, along with the current value of the firm's stock price.
Following are some of the factors lenders consider when evaluating an individual or business that is seeking credit:
Credit worthiness. A history of trustworthiness, a moral character, and expectations of continued performance demonstrate a debtor's ability to pay. Creditors give more favorable terms to those with high credit ratings via lower point structures and interest costs.
Size of debt burden. Creditors seek borrowers whose earning power exceeds the demands of the payment schedule. The size of the debt is necessarily limited by the available resources. Creditors prefer to maintain a safe ratio of debt to capital.
Loan size. Creditors prefer large loans because the administrative costs decrease proportionately to the size of the loan. However, legal and practical limitations recognize the need to spread the risk either by making a larger number of loans, or by having other lenders participate. Participating lenders must have adequate resources to entertain large loan applications. In addition, the borrower must have the capacity to ingest a large sum of money.
Frequency of borrowing. Customers who are frequent borrowers establish a reputation which directly impacts on their ability to secure debt at advantageous terms.
Length of commitment. Lenders accept additional risk as the time horizon increases. To cover some of the risk, lenders charge higher interest rates for longer term loans.
Social and community considerations. Lenders may accept an unusual level of risk because of the social good resulting from the use of the loan. Examples might include banks participating in low-income housing projects or business incubator programs.
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