Capital investments and capital structure

Where did the capital come from, and where did it go?

Over any period, the money that came in equals the money that went out. A sources and uses of capital table lays both sides over several years, so the analyst can read a story: is the company reinvesting, buying growth, or returning cash? Is it funding itself from operations, or by borrowing?

Capital over a periodsources always equal uses

• Sources Use it where the money came from
  • Cash flow from operations including negative net working capital
  • Cash and investments on hand drawing down the balance
  • Debt issuance
  • Equity issuance
  • Asset disposals
• Uses Use it where it went
  • Capital expenditures and additions to intangibles
  • Acquisitions
  • Increase in net working capital
  • Debt repayment
  • Dividends and share repurchases

Here is a five-year illustration for Clearspring (USD million). Sources: operations 14.0, new debt 5.0, asset sales 1.0, total 20.0. Uses: capital spending 9.0, one acquisition 4.0, dividends 5.0, buybacks 2.0, total 20.0.

Operations (14.0) fall short of the payouts and investment together (20.0), so new debt of 5.0 and asset sales of 1.0 fill the gap. Debt has risen to help fund payouts and an acquisition. That points to growing financial leverage, which the later ratios put a number on.

Did the investment create value?

Memorize

Management judges projects with net present values (NPVs) and internal rates of return (IRRs), which outsiders cannot see. Analysts use aggregate measures instead and look at the trend over many years. The main one is return on invested capital : the after-tax operating profit a company earns on the capital invested in it by lenders and shareholders.

$$ROIC = \frac{NOPAT}{\text{invested capital}}, \quad NOPAT = EBIT \times (1 - t)$$

Invested capital is debt plus equity (or, from the other side, operating assets net of operating liabilities). The comparison benchmark is the weighted average cost of capital (WACC): the blended cost of the debt and equity that fund the business. ROIC is a return to all capital providers, so it is compared with the cost of all capital.

$$\text{Spread} = ROIC - WACC$$

ROIC is an unlevered return, so it belongs next to an all-capital cost like WACC. The return that shareholders earn after leverage is return on equity (ROE), and the DuPont analysis breaks it into net margin, asset turnover and an equity multiplier. Leverage lifts ROE above the unlevered return.

ROElevered return to shareholders

• Net margin net income ÷ revenue
• Asset turnover revenue ÷ assets
• Equity multiplier Use it assets ÷ equity; leverage

$$ROE = \frac{NI}{\text{revenue}} \times \frac{\text{revenue}}{\text{assets}} \times \frac{\text{assets}}{\text{equity}}$$

For Clearspring, with interest of 1.0 the net income is (3.0 − 1.0) × 0.75 = 1.5. Debt is 10.0 and equity 10.0, and with payables of 1.0 total assets are 21.0. Net margin 1.5 ÷ 18.0 = 8.33%, asset turnover 18.0 ÷ 21.0 = 0.857, equity multiplier 21.0 ÷ 10.0 = 2.1. Product: 15.0%, well above the 11.25% ROIC. That gap is the lift from leverage.

How risky is the financing?

Memorize

Financing risk shows up in leverage ratios, coverage ratios, credit ratings and in the degree of financial leverage (DFL): how much net income moves when operating income moves. It is the financing twin of operating leverage, but driven by fixed interest instead of fixed operating costs.

Is the capital structure risky?unlevered returns versus what leverage adds

• Leverage ratios Use it how much debt
  • Net debt to EBITDA Use it years of earnings to repay
• Coverage ratios Use it can earnings pay the interest
  • Interest coverage Use it EBIT ÷ interest expense
• Sensitivity Memorize
  • Degree of financial leverage Memorize %Δ net income ÷ %Δ operating income
• Third-party view
  • Credit ratings from rating agencies

$$DFL = \frac{\%\Delta \text{net income}}{\%\Delta \text{operating income}}$$

$$DFL = \frac{EBIT}{EBIT - I}$$

With fixed interest $I$, a change in EBIT lands wholly on the profit after interest, so the same change is a larger percentage of a smaller base. Taxes cancel when the rate is constant.

$$\frac{\text{debt} - \text{cash and investments}}{EBITDA}$$

$$\text{Interest coverage} = \frac{EBIT}{\text{interest expense}}$$

Net debt to EBITDA shows roughly how many years of operating earnings it would take to repay net debt. Interest coverage shows how many times earnings cover the interest bill.

$$\%\Delta \text{net income} = DOL \times DFL \times \%\Delta \text{sales}$$

Exam tip DFL is not a constant. As EBIT falls toward the interest bill, the denominator EBIT − I shrinks and DFL climbs, which is why highly indebted firms are fragile in downturns.

Go deeper Why excess cash lowers ROIC

Invested capital counts cash and investments sitting on the balance sheet, but that cash earns little operating profit. For Clearspring, removing the 1.6 of cash lifts ROIC from 2.25 ÷ 20.0 = 11.25% to 2.25 ÷ 18.4 = 12.23%. A large gap between ROIC and ROIC excluding cash tells you the company is hoarding cash, either for safety or because it has no good projects. Either way, it could invest it or return it.

Go deeper Why some stable businesses still avoid debt

A thin margin makes interest hard to cover when sales dip, so a company with a low operating margin may choose little debt even if its sales are steady. Conversely, a business with predictable revenue (necessities, recurring fees) can carry more. Debt capacity depends on the stability of earnings and on fixed costs already in the business, which is why DOL and DFL are read together.