Capital investments and capital structure

Where does the cash for shareholders come from?

Memorize

A company analysis also reads the balance sheet: investment in working capital, in long-term assets, and new financing. Free cash flow to equity (FCFE) ties them together. It is the cash left for shareholders once operating expenses and taxes are paid and all the investment needed to keep and grow the business is made (the discounted cash flow module values shares with it).

$$FCFE = \text{NI} + \text{D\&A} - \Delta\text{WC} - \Delta\text{LT assets} + \Delta\text{Debt}$$

• ΔWC = Δ current assets − Δ current liabilities
• ΔDebt (net debt issuance ) = new borrowing − debt repaid

Sources are net income (NI), the non-cash depreciation and amortization (D&A) charge and new debt; uses are growth in working capital (WC) and in long-term (LT) assets. Here Δ long-term assets is the year’s investment in them, the capital expenditure.

FCFEcash left for shareholders

• Sources Memorize
  • Net income
  • D&A (non-cash)
  • Net debt issuance
• Uses Memorize
  • Increase in working capital
  • Investment in long-term assets

FCFE varies across companies, industries and the life cycle. Start-ups and young growth firms often have negative FCFE: they invest heavily and lack the steady cash flows needed to carry debt. As firms mature, they need less new investment and can use more debt (Lesson 2).

Did the investment create value?

Memorize

Capital investments in long-term tangible and intangible assets are capitalized, and those with a finite life are expensed over time through D&A. So analysts watch net capital expenditure , capital expenditure minus D&A, as a measure of how much a company is adding to its productive capacity.

$$\text{Net capital expenditure} = \text{capital expenditure} - \text{D\&A}$$

With capital expenditure of 2.0 and D&A of 1.2, net capital expenditure is 2.0 − 1.2 = 0.8, so capacity is growing. Negative means the asset base is shrinking.

The business model sets how much a company must invest: carmakers and aircraft makers carry heavy tangible assets, service and technology firms earn with a small, efficient asset base, and companies that license software or other intellectual property hold mostly intangible assets amortized over their useful lives (asset-heavy and asset-light business models ).

The level of investment matters, but analysts focus on the return it earns. Return on invested capital (ROIC) is an aggregate measure of value creation across all of a company’s investments: the after-tax operating profit earned for all investors, lenders and shareholders alike.

$$ROIC = \dfrac{\text{NOPAT}_t}{\text{Average invested capital}}$$

• Net operating profit after taxes (NOPAT) = operating income × (1 − tax rate)
• Invested capital = total long-term liabilities + total equity, averaged over the start and end of the period

ROIC is compared with the weighted average cost of capital (WACC) , the blended cost of all the capital. A positive difference is an excess accounting return for investors.

$$\text{Excess accounting return} = ROIC - WACC$$

Or use the ratio ROIC ÷ WACC, above 1 when ROIC beats WACC.

ROIC is a return to all capital providers, so it is compared with the cost of all capital (WACC), never with the cost of equity. Industry analysis uses the same ROIC to compare whole industries; here it compares a company with its peers over several years.

How risky is the financing?

Memorize

A company’s best capital structure depends on its business model, its operations and asset conversion cycle, and its life-cycle stage. Early-stage firms with high business risk, little revenue and negative cash flow are usually financed with equity; mature businesses with stable cash flows can support debt. Analysts look at how much the company relies on debt, the type and tenor of its bonds and loans, and its access to more debt.

Long-lived assets, as in manufacturing or utilities, are often financed with long-term bonds; retail and service businesses tend to fund themselves for shorter terms. When a company ramps up investment, restructures or buys another company, the change in debt belongs in the forecast model so that interest and repayments are captured.

Is the capital structure risky?fits the business model, asset life and life-cycle stage?

• Leverage ratios
  • Total debt to total assets Use it
  • Debt to equity Use it
• Coverage
  • EBITDA to interest expense Use it
• Sensitivity
  • Degree of financial leverage Memorize %Δ net income ÷ %Δ operating income
• Direction
  • Leverage rising debt-funded acquisition or expansion
  • Deleveraging debt falls, coverage rises

The income statement shows the effect of debt through the degree of financial leverage (DFL): the sensitivity of net income to changes in operating income. It rises as interest expense grows relative to net income. Like operating leverage, it magnifies gains and losses, and it raises the chance of financial distress : serious uncertainty about whether the company can meet its debt obligations because earnings are weak or it is making losses.

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

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

With fixed interest $I$, a change in operating income (EBIT, earnings before interest and taxes) lands wholly on the profit after interest, so the same change is a larger percentage of a smaller base. This shortcut follows from the definition when interest is fixed and the tax rate constant.

Two balance-sheet and coverage measures complete the picture. Total debt to total assets shows how much of the asset base debt funds; EBITDA to interest expense shows how many times earnings before interest, taxes, depreciation, and amortization (EBITDA) cover the interest bill.

$$\dfrac{\text{total debt}}{\text{total assets}}$$

$$\dfrac{\text{EBITDA}}{\text{interest expense}}$$

The debt-to-equity ratio (debt ÷ equity, 10.0 ÷ 10.0 = 1.0 for Clearspring) tells the same story from the equity side.

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

What does deleveraging look like?

After a large acquisition financed with debt, the debt ratio jumps and interest coverage falls. The analyst should explain the rise in leverage and judge whether the company’s plan to bring it down is realistic. Deleveraging shows as falling debt, a falling debt-to-equity ratio and rising interest coverage. A debt ratio that keeps rising, or coverage that keeps falling, means leverage is still going up, whatever happens to profits.

Negative working capital and steady FCFE can fund the repayments (Lesson 4).

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 operating and financial leverage are read together.