Principles of Corporate Finance_ 12th Edition

746 Part Nine Financial Planning and Working Capital Management

bre44380_ch28_732-758.indd 746 10/06/15 09:49 AM

The company enjoys a comfortable interest coverage or times-interest-earned ratio. Some-

times lenders are content with coverage ratios as low as 2 or 3.

The regular interest payment is a hurdle that companies must keep jumping if they are to

avoid default. Times-interest-earned measures how much clear air there is between hurdle and

hurdler. The ratio is only part of the story, however. For example, it doesn’t tell us whether

Home Depot is generating enough cash to repay its debt as it comes due.

Cash Coverage Ratio In the previous chapter we pointed out that depreciation is deducted

when calculating the firm’s earnings, even though no cash goes out the door. Suppose we add

back depreciation to EBIT to calculate operating cash flow.^16 We can then calculate a cash

coverage ratio. For Home Depot,

Cash coverage =

EBIT + depreciation

_________________

interest payments

=

9,178 + 1,627

____________

711

= 15.2

Leverage and the Return on Equity

When the firm raises cash by borrowing, it must make interest payments to its lenders. This

reduces net profits. On the other hand, if a firm borrows instead of issuing equity, it has fewer

equityholders to share the remaining profits. Which effect dominates? An extended version of

the Du Pont formula helps us answer this question. It breaks down the return on equity (ROE)

into four parts:

ROE = _________net income

equity

= ______assets

equity

× _____sales

assets

× after-tax interest + net income_________________________

sales

× _________________________net income

after-tax interest + net income

↑ ↑ ↑ ↑

leverage

ratio

asset

turnover

operating

profit margin

“debt burden”

Notice that the product of the two middle terms is the return on assets. It depends on the firm’s

production and marketing skills and is unaffected by the firm’s financing mix. However, the

first and fourth terms do depend on the debt–equity mix. The first term, assets/equity, which

we call the leverage ratio, can be expressed as (equity  +  liabilities)/equity, which equals

1 + total-debt-to-equity ratio. The last term, which we call the “debt burden,” measures the

proportion by which interest expense reduces net income.

Suppose that the firm is financed entirely by equity. In this case, both the leverage ratio and

the debt burden are equal to 1, and the return on equity is identical to the return on assets. If

the firm borrows, however, the leverage ratio is greater than 1 (assets are greater than equity)

and the debt burden is less than 1 (part of the profits is absorbed by interest). Thus leverage

can either increase or reduce return on equity. You will usually find, however, that leverage

increases ROE when the firm is performing well and ROA exceeds the interest rate.

(^16) Earnings before interest, taxes, depreciation, and amortization are often termed EBITDA.
28-8 Measuring Liquidity
If you are extending credit to a customer or making a short-term bank loan, you are interested
in more than the company’s leverage. You want to know whether the company can lay its
hands on the cash to repay you. That is why credit analysts and bankers look at several mea-
sures of liquidity. Liquid assets can be converted into cash quickly and cheaply.