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(^306) Financial Management
is the mtio of net cash inflows to fixed charges (debt-servicing ratio). It indicates the
number of times the fixed financial obligations are covered by the net cash inflows
generated by the company.
The greater the coverage, the greater is the amount of debt a company can use. However,
a company with a small coverage can also employ a large amount of debt if there are
not significant yearly variance in its cash inflows and a small probability of the cash
inflows being considerably less to meet fixed charges in a given period. Thus, it is not
the average cash inflows but the yearly cash inflows which are important to determine
the debt capacity of a company. Fixed financial obligations must be met when due, not
on an average or in most years but, always.' This requires a full cash flow analysis.
Debt Capacity
The technique of cash flow analysis is helpful in determining the firm's debt capacity.
Debt capacity is the amount which a firm can service easily even under adverse
conditions; it is the amount that the firm should employ. There may be lenders who are
prepared to lend to you. But you should borrow only if you can service debt without any
problem. A firm can avoid the risk of financial distress if it can maintain its ability to
meet contractual obligation of interest and principal payments. Debt capacity, therefore,
should be thought in terms of cash flows rather than debt ratios. A high debt ratio is not
necessarily bad. If you can service high debt without any risk, it will increase shareholders'
wealth. On the other hand, a low debt ratio can prove to be burdensome for a firm
which has liquidity problem. A firm faces financial distress (or even insolvency) when
it has cash flow problem. It is dangerous to finance a capital intensive project out of
borrowings which has built in uncertainty about the earnings and cash flows. National
Aluminium Company is an example of a wrong initial choice of capital structure, without
analysing the company's debt servicing ability.
Exhibit 2: Debt Burden Under Cash Crunch Situation: Case of NALCO
National Aluminium Company (NALCO), started in 1981, is the largest integrated aluminium
complex in Asia of total investment of Rs 2,408;crore, borrowings from a consortium of
European banks financed to the extent of $ 830 million or Rs 1,119 crore (46.5 per cent). The
loan was repayable by 1995. Aluminium is an electricity-intensive business; each tonne of
aluminium needs over 15,000 kw of electricity. Since its commissioning in 1988, Nalco has
exported substantial portion of its production since the domestic demand has been very low
than what the company had projected at its inception. The falling international prices in last
few years have eroded the company's profitability. The net profit of Rs 172 crore in 1989
dropped to Rs 14 crore in 1991-92. The he 1,119 crore Eurodollar loan has appreciated to Re
2,667 crore inspite of having repaid Rs 644 crore. Due to profitability and liqu:,dity problem
and hit by the depreciating rupee and the liberalised exchange mechanism, the company is