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Long-Term Debt-Paying Ability

Updated on November 2, 2011

I am not an early riser but I had set my alarm at 6:00 am to enjoy the sunrise in the desert by just hopping on the rooftop of a lone bungalow, I was staying in. The sunrise in November was absolutely breathtaking. Afterward, I had a little stroll in the nearby area. It was very scenic with sand dunes everywhere and of every type: parabolic, transverse and barchans.

I had come to attend a meeting of voluntary bankruptcy of a company,Thal Textile Mills Ltd, located in the midst of a desert with same name. The owners of the company were shaky, there was hardly any cash or bank balances, payables had piled up and receivables were mostly uncollectible. What had led to such despair, was it inefficiency or dishonesty, it hardly matters now. It is unfortunate that filing for voluntary bankruptcy had become inevitable as debts were far exceeding the assets. It seemed the only way of addressing the financial woes.

Warning Signals on bankruptcy

There are always tell-tale signs before a company reaches a point where it could be forced to go into bankruptcy. Warning signals are unmistakable. Unpaid bills go on mounting, bank officials call frequently while stocks and stores, pledged with them, are frozen.

Edward I. Altman developer z-score formula for prediction bankruptcy
Edward I. Altman developer z-score formula for prediction bankruptcy

Altman, a financial economist, has developed a formula. It requires some financial parameters that give an indication of expected bankruptcy. It is named as Z Score but it should not be confused with z-table of area under the normal curve. Besides, World Bank has set some bench-marks like Time-Interest Earned, Debt Service Cover, Debt/Equity Ratio and Fixed Assets Cover. When a company falls short of these bench-marks, it is surely heading for bankruptcy.

To safeguard their interests, the banks include in the loan agreements the desired bench-marks and may recall their loans if they feel that the borrowers are not adhering to their commitments.

These would be briefly described in the following paragraphs.

Availability of Annual Reports and Accounts

Private Ltd Companies like Thal Textile Mills Ltd are not required to make public their annual reports and accounts. Hence all further financial information would be on Packages Ltd as in the previous hubs.

Current and Fixed Assets

The sketch shows fixed assets which are increase gradually and current assets which are fluctuating widely. But there is a certain level of current assets which do leave the business, hence called permanent working capital.
The sketch shows fixed assets which are increase gradually and current assets which are fluctuating widely. But there is a certain level of current assets which do leave the business, hence called permanent working capital.

Capital Structure

Capital structure represents permanent funds i.e. long-term liabilities and equity. Current liabilities are not included in the capaital structure as they fluctuate from time to time because of changes in sale-levels on account of seasonal variations.

A garment factory may experience many seasons because of various festivals. On the other hand, a sugar mill would have highest stock of white-sugar in cane crushing season lasting for 140 to 150 days in a year. Naturally, its short-term liabilities, mainly bank loans, would be high. These stocks would go down gradually once the crushing season is over.

To see the magnitude of capital structure, the formula is:

Total Assets - Current Liabilities = Long Term Liabilities + Equity = Capital Structure

DEBT BURDON

FINANCIAL CRISIS

LONG TERM LIABILITIES:

These are part of capital sturucture. As the name implies, long term liabilities are expected to earn some sort of profit or benefit later rather than sooner.

Term loans are major type of long-term liabilities. These loans have generally fixed interest rates, semi-annual repayment schedules and set maturity dates. These are collateralized by fixed assets of a business and are bound by many covenants limiting additional financial commitments, declaration of dividends and changes in product lines. Term loans are suitable for construction, machinery expansion and even permanent working capital.

Long-term liabilities are listed below:

  • Debentures
  • Mortgage Loans
  • Supplier’s Credit
  • Foreign currency loans
  • Local currency Loan:
  • long-term notes,
  • Employee pension obligations
  • Long-term lease liabilities.
  • Deferred Taxation
  • Accumulated compensated absences

DEBT/EQUITY RATIO

Debt / Equity of Packages Ltd.

As of Dec 31, debts of Packages Ltd were Rs.13.145 million as against equity of Rs.16.272 million giving a debt equity ratio of 45/55. It is like blend used in cloth weaving such as 15% polyester, 85% cotton. Naturally, if %polyester goes up, %cotton goes down. More %polyester would degrade the quality of the fabric.

Packages Ltd is a financially strong company for various reasons. First, its debt/equity ratio is positive as equity exceeds debt. Second, the company has strong presentation in the market and its sales are increasing each year. Third, it has an adequate fixed asset base. To sum up, good market prospect, presence of fixed assets and a positive debt/equity ratio would make lenders comfortable and they may extend even more funds at the time of any financial distress.

FIXED ASSETS COVER TO DEBT

Maximum Borrowings

There is no set rule as to how much indebtedness a company may contract. It depends upon business risk. Companies with traditional products having stable demand may take larger loans than those companies with shaky businesses. Another factor is cost-structure. Companies with high fixed costs are more prone to risk than those companies which have high variable costs. This is measured by "Degree of operating leverage".

There are three main ratios to find out if a company has over-borrowed?

DEBT SERVICE COVER

  • It shows the number of time a company can pay full installments of its loan.
  • It should normally be above 2 times and still more if the demand is uncertain

TIMES INTEREST EARNED

  • It shows how many times, interest has been earned from operating profit. (Debt service Cover ratio has more items like depreciation and amortization).
  • Like debt servicing, times interest earned should also be above 2.

FIXED ASSETS COVER

  • Since securities of long term loans is mortgage of fixed assets, the lender always examine fixed asset of the company vis-a-vis its long term debts.
  • The cover should be adequate keeping in view market value of the fixed assets and the ease with which these can be disposed off in case of bankruptcy.

DEBT/EQUITY RATIO

Conclusion

A company must take all measures to remain solvent. Economic down-turns are normal which would affect everyone in trade,commerce and industry..

A periodic review of a company's financial strength is a must. This includes some ratios which should constantly be compared with industrial ratios. Any major deviation should be investigated to find out if it is in the interest of the company or against it. A stitch in time would save the company from going into liquidation.

Major ratios pertaining to solvency are: (i) time interest earned, (ii) debt service cover, (iii) debt/equity ratio and (iv) fixed assets cover.

Business journals or government functionaries periodically issue important industrial ratios. If there are no such information, one can obtain annual accounts of the companies from the Internet or stock-exchanges for a comparative study.

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Comments

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    • hafeezrm profile imageAUTHOR

      hafeezrm 

      4 years ago from Pakistan

      Thanks @prasadjain for your comment.

    • prasadjain profile image

      Dr.S.P.PADMA PRASAD 

      4 years ago from Tumkur

      A very good hub on economic management of companies,who want to survive,serve and develop. A well organized hub with vast study and experience in the background.

    • hafeezrm profile imageAUTHOR

      hafeezrm 

      8 years ago from Pakistan

      Analysing Bank of America or JP Morgan is an uphill task. First, I have to study the environments in which they are operating, second, I would have to construct a scenario of the desired behavior of a bank an finally comparing the two to find out lapses. This would involve study of past accounts and some correspondance seeking clarification.

      I am thousands of miles away besides being fully engaged in my own teaching and writing assignments and, therefore, would not be in a position to undertake such task.

    • bgamall profile image

      Gary Anderson 

      8 years ago from Las Vegas, Nevada

      Oh yes, please let me know when you complete the analysis. Again, I don't know if you have the resources or transparency to be able to complete a task so large. :)

    • hafeezrm profile imageAUTHOR

      hafeezrm 

      8 years ago from Pakistan

      Thanks @bgamall for your comments. Some error in you sentence "if you complete them". Please clarify.

    • bgamall profile image

      Gary Anderson 

      8 years ago from Las Vegas, Nevada

      Very smart article. Hafeezrm, it would be interesting to apply this discipline to the too-big-to-fail banks to see their capital strength. Of course that is difficult if they can't even figure out what their liabilities are worth!

      I would like you to do an analysis of Bank of America and JP Morgan and Citibank and please let me know if you complete them. I realize that this would be quite a task. Maybe pick one. I realize that these companies are not very transparent as to liabilities and it may not be possible to complete an assessment.

    • hafeezrm profile imageAUTHOR

      hafeezrm 

      8 years ago from Pakistan

      Thanks for your comments. The company stands liquidated. Its assets were auctioned and were purchased by another party. They are operating with some other name but just lingering on. Main reason is isolated location creating shortage of labor every now and then.

    • Rufi Shahzada profile image

      Rufi Shahzada 

      8 years ago from Karachi

      Dear Sir,

      Thanks a lot for such a nice and informative hub. I have a question about THAL TEXTILE LTD. What was the end result of that meeting? Are they in operations now?

      RUFI SHAHZADA

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