Cash Flow Analysis
EBIT-EPS analysis and coverage ratios are very useful in making explicit the impact of leverage on EPS and on the firm’s ability to meet its commitments at various levels of EBIT. But the EBIT is interest ratio is less than a perfect measure to analyse the firm’s ability to service fixed charges because the firm’s ability to do so depends on the total payments required, that is, interest and principal, in relation to the cash flow available to meet them. Therefore, the analysis of the cash flow ability of the firm to service fixed charges is an important exercise to be carried out in capital structure planning in addition to profitability analysis. The exercise is of overwhelming significance in the context of the risk of bankruptcy. If the firm borrows more than its debt capacity and, therefore, fails to meet its obligations in future, the lenders may size the assets of the company to satisfy their claims. Thus, the basic existence of the company would be endangered.
It may be possible that the company’s EBIT is adequate to cover its specific commitments, . arising out of debt obligations; but, the firm may not have sufficient cash to pay as its income is blocked within the firm in the form of higher inventory, receivables and/or sometimes purchases of fixed assets, particularly, when the company is a growing one. In the absence of cash flow analysis, a company, which is otherwise profitably sound, would, in case of default, run is to great difficulties. Thus, cash flow analysis is an essential ingredient of any sound capital structure decision.
Cash flow analysis yields a number of distinct advantages in the crucial task of setting debt policy: (i) it focuses on the solvency of the firm during’ adverse circumstances in contrast to EBIT – EPS analysis which is concerned with the effects of leverage under normal circumstances: (ii) it takes into consideration the balance sheet changes and other cash flows that do not appear in the profit and loss account; (iii) it gives an insight into the inventory of financial resources available in the event of recession; and (iv) finally, it views the problem in a dynamic context over time whereas EBIT/EPS and coverage analysis normally consider only a single year. From all these points, it can be concluded that the cash flow analysis evaluates the risk of financial distress and should be recognized as a good supporting supplement to the EBIT/EPS analysis in framing the firm’s capital structure.
Suppose, the firm is of the view that 5 per cent is the maximum profitability of not having cash to meet charges that can be tolerated (i.e. it will not cause insolvency). Further, suppose that the actual probability of being out of cash on the basis of the cash budget prepared under adverse circumstances is also 5 per cent. In such a situation, according to Van Home, debt can be employed up to a point where the cash balance is just sufficient to cover the fixed charges. That is to say, debt can be increased up to the point at which the additional cash drain would cause the probability of cash insolvency to equal the risk tolerance specified by management. It is, of course, not necessary that the debt would be increased to that point. This method of analysis suggested by Van Horne provides a means for assessing the effect of increase in debt on the risk of cash insolvency. On the basis of the information available from this analysis, the firm would determine the most appropriate level of debt.
A similar type of analysis has been suggested by Gordon Donaldson. It is argued that a firm will nominally be able to meet its fixed obligations in terms of interest as well as repayment of principal. It is only during adverse circumstances that firms will not be able to maintain their ability to meet contractual obligations and would be exposed to the risk of bankruptcy or the extreme form of risk of financial distress. Donaldson terms these as recession conditions. To examine the impact of alternative debt policies on the risk of bankruptcy, therefore, what is required is a careful analysis of how a firm’s cash flows would be affected by recession conditions. We illustrate below the effect of alternative debt policies on the risk of bankruptcy so , is to determine debt capacity or optimum amount of debt appropriate to a particular firm.