CARLOS HILADO MEMORIAL STATE COLLEGE

Talisay City, Negros Occidental

School of Graduate Studies
S.Y. 2018-2019

Topic: Financial Analysis Tools (debt coverage, leverage, etc.)

Reporter: Johna Mae D. Etang
Professor: Dr. Ernesto Java

Debt Coverage
In order to fully analyze the strength of a company’s income and cash flow, it has to be compared against the required
debt payments that the company needs to make. To fully analyze this relationship of income and cash flow compared to
debt service,
3 basic ratios have been outlined below:

Times Interest Earned Ratio

Debt Service Coverage Ratio
Cash Flow from Operations Debt Service Coverage Ratio

Times Interest Earned Ratio: The times interest earned ratio is expressed as the operating income of the company
divided by the interest expense of that company:
Operating Income
Interest Expense
The operating income of a company can be found as a subtotal on the company’s income statement after all operating
expenses have been taken into account. Other income/expenses can often fluctuate and include one-time items, but the
operating income/profit represents the income from core (normal) operations. This is the amount of interest that was
due and payable in the particular period that the income statement covers.

Note:
An interest expense is the cost incurred by an entity for borrowed funds. Interest expense is a non-operating
expense shown on the income statement. It represents interest payable on any borrowings – bonds,
loans, convertible debt or lines of credit.

Debt-Service Coverage Ratio (DSCR)

In corporate finance, the Debt-Service Coverage Ratio (DSCR) is a measure of the cash flow available to pay
current debt obligations. The ratio states net operating income as a multiple of debt obligations due within one year,
including interest, principal, sinking-fund and lease payments.

In government finance, it is the amount of export earnings needed to meet annual interest and principal payments on a
country's external debts.
In personal finance, it is a ratio used by bank loan officers to determine income property loans.
In general, the debt-service coverage ratio is calculated as:

DSCR = Net Operating Income / Total Debt Service

Components of the Debt-Service Coverage Ratio
The formula for debt-service coverage ratio requires net operating income and total debt service of the entity. Net
operating income is a company's revenue minus its operating expenses, not including taxes and interest payments. It is
often considered equivalent of earnings before interest and tax (EBIT). Some calculations include non-operating income in
EBIT, however, which is never the case for net operating income. As a lender or investor comparing different companies'
credit-worthiness – or a manager comparing different years' or quarters' – it is important to apply consistent criteria when
calculating DSCR. As a borrower, it is important to realize that lenders may calculate DSCR in slightly different ways.

Total debt service refers to current debt obligations, meaning any interest, principal, sinking-fund and lease payments that
are due in the coming year. On a balance sheet, this will include short-term debt and the current portion of long-term
debt.

Interpreting the Debt-Service Coverage Ratio

Lenders will routinely assess a borrower's DSCR before making a loan. A DSCR of less than 1 (one) means negative cash
flow which means that the borrower will be unable to cover or pay current debt obligations without drawing on outside
sources—without, in essence, borrowing more. or example, DSCR of .95 means that there is only enough net operating
income to cover 95% of annual debt payments. In the context of personal finance, this would mean that the borrower
would have to delve into his or her personal funds every month to keep the project afloat. In general, lenders frown on a
negative cash flow, but some allow it if the borrower has strong resources outside income. If the debt-service coverage
ratio is too close to 1, say 1.1, the entity is vulnerable, and a minor decline in cash flow could make it unable to service its
debt. Lenders may in some cases require that the borrower maintain a certain minimum DSCR while the loan is
outstanding. Some agreements will consider a borrower who falls below that minimum to be in default. Typically, a
DSCR greater than 1 means the entity – whether a person, company, or government – has sufficient income to pay its
current debt obligations.

Cash Flow from Operations Debt Service Coverage Ratio: This ratio is the same as the one above, but uses the
cash flow from operations instead of EBIDA in the numerator:

Cash Flow from Operations

CPLTD + Current Portion of Capital Leases + Interest Expense
(current portion of long-term debt )
*Interest expense should be added back if using the indirect method.
The cash flow from operations can be found as a subtotal on the statement of cash flows. This is the cash flow that has
been generated from the operating activities of a company and includes changes in certain balance sheet accounts such as
A/R, inventory, and A/P to show the actual cash inflows and outflows of a business. This is slightly different than the
operating profit and EBIDA of a company that shows the inflows and outflows of receipts, but does not tell you if they
were paid or not. Since most companies use the indirect method starting with net income [and depreciation/amortization]
at the top, interest expense will need to be added back just as it was with the last two ratios.

Times Interest Earned Ratio: Operating income divided by interest expense: should be over 1 to pay interest expense
on debt, and usually has a cushion of 1.5:1 or higher.
Debt Service Coverage Ratio: Earnings/income (E) of a company before (B) the sum of interest expense (I),
depreciation (D), amortization (A), and any other non-cash items, divided by the sum of current portion of long-term debt
(CPLTD), current portion of capital leases, and interest expense: should be over 1 to cover required debt payments with
healthy companies reporting 1.25:1 or higher.

Cash Flow from Operations Debt Service Coverage Ratio: Cash Flow from Operations (add back interest
expense if using the indirect method) divided by the sum of current portion of long-term debt, current portion of capital
leases, and interest expense: should be over 1 to cover required debt payments with healthy companies reporting 1.25:1
or higher.

LEVERAGE
Leverage results from using borrowed capital as a funding source when investing to expand the firm's asset base and
generate returns on risk capital. Leverage is an investment strategy of using borrowed money — specifically, the use of
various financial instruments or borrowed capital — to increase the potential return of an investment. Leverage can also
refer to the amount of debt a firm uses to finance assets. When one refers to a company, property or investment as
"highly leveraged," it means that item has more debt than equity.

Example of Leverage
A company formed with an investment of P5 million from investors, the equity in the company is P5 million; this is the
money the company can use to operate. If the company uses debt financing by borrowing P20 million, it now has P25
million to invest in business operations and more opportunity to increase value for shareholders. An automaker, for
example, could borrow money to build a new factory. The new factory would enable the automaker to increase the
number of cars it produces and increase profits.

Leverage Formulas
Through balance sheet analysis, investors can study the debt and equity on the books of various firms and can invest in
companies that put leverage to work on behalf of their businesses. Statistics such as return on equity, debt to equity
and return on capital employed help investors determine how companies deploy capital and how much of that capital
companies have borrowed. To properly evaluate these statistics, it is important to keep in mind that leverage comes in
several varieties, including operating, financial and combined leverage.

DuPont analysis uses the "equity multiplier" to measure financial leverage. One can calculate the equity multiplier by
dividing a firm's total assets by its total equity. Once figured, one multiplies the financial leverage with the total asset
turnover and the profit margin to produce the return on equity. For example, if a publicly traded company has total assets
valued at P500 million and shareholder equity valued at P250 million, then the equity multiplier is 2.0 (P500 million / P250
million). This shows the company has financed half its total assets by equity. Hence, larger equity multipliers suggest more
financial leverage.

Downside of Leverage
Leverage is a multi-faceted, complex tool. The theory sounds great, and in reality, the use of leverage can be profitable,
but the reverse is also true. Leverage magnifies both gains and losses. If an investor uses leverage to make an investment
and the investment moves against the investor, his or her loss is much greater than it would've been if he or she had not
leveraged the investment. In the business world, a company can use leverage to generate shareholder wealth, but if it fails
to do so, the interest expense and credit risk of default destroy shareholder value.