Chapter 14: Additional Ratio Analysis
Ratios are a means of measuring a given company’s performance over different periods of time. Some ratios that are very common in leveraged buyout analysis include:
- total debt to equity
- total debt to capital
- total debt to EBITDA
- net debt to EBITDA
- EBITDA to interest
- EBIT to interest.
We will discuss each of these ratios and explain how to calculate them in our example model.
Before we dive into the calculations of our ratios we must first forecast any changes to shareholders’ equity. Let’s turn our attention to the shareholders’ analysis portion of our spreadsheet. We will calculate changes in shareholders’ equity by first establishing what our equity value would be in Year 0, at the point just after completion of the leveraged buyout transaction. Year 0 shareholders’ equity will be equal to the initial equity investment minus the transaction fees. Your formula in cell (P54) should look like the following: =F12-F8. (We are assuming purchase accounting.)
The beginning shareholders’ equity balance in Year 1 will be equal to the ending balance in Year 0. Therefore, you will want to set your Year 1 beginning balance in cell (Q52) equal to the formula: =P54. This should be straightforward. In order to arrive at the ending balance for shareholders’ equity we would need to normally add net income after subtracting out any dividends and also take into consideration any stock repurchases or issuances made by the company. In our example, the company is not issuing nor is it purchasing back any of its stock. We assume that the company will not being paying a dividend over the explicit forecast range. For this reason, we can arrive at changes to shareholders’ equity/retained earnings by just referencing pro forma net income for the period. Your formula for changes to shareholders’ equity in Year 1 (Q53) should look like the following: =F47
Shareholders’ equity
All of our assumptions are reasonable, as long as we believe the new owners of the company will carry this strategy out in practice. If you are unsure, you can model alternative scenarios to forecast out the performance of the target company under alternative circumstances. It is more likely than not that you will want to look at several different scenarios in building your analysis.
As you may have guessed, in order to arrive at the ending balance for shareholders’ equity we simply need to add our beginning balance with changes to shareholders’ equity/retained earnings. Your formula for shareholders’ equity ending balance should look like the following: =SUM(Q52:Q53)
Use the keyboard shortcut ALT+EQUALS to calculate shareholders’ equity ending balance and save yourself a few key strokes at the same time.
Now that you have completed forecasting the changes in shareholders’ equity for Year 1, let’s complete the forecasts for all of the following pro forma years. In order to do this, begin by going to the beginning balance of shareholders’ equity for Year 1. Hold down the SHIFT key and use the arrow keys to navigate down and across to the ending balance of shareholders’ equity in Year 5 to highlight the entire pro forma area of the shareholders’ equity analysis. We can use our CTRL+R shortcut to apply the same logic that we created for Year 1 across the remaining pro forma years. You have now completed the pro forma shareholders’ equity analysis.
Our final concern at this point is measuring the leverage and credit statistics of our target company. For this we will take a look at each statistic. We want to understand both how to calculate the statistics and what they are telling us.
Debt Ratios
Total debt to equity
Total debt to equity measures the leverage that our company is using to finance the assets on its balance sheet. A low debt to equity ratio is considered a conservative approach to financing the assets on a company’s balance sheet. A higher debt to equity ratio on the other hand is considered more aggressive, as there will be additional interest expense which will increase the risk of default if revenues decline over time. In our example model, we are analyzing the target company under the assumption that it is financing the assets on its balance sheet with much more debt. This is considered considerably riskier than its current capital structure, which consists of very little debt financing and subsequently incurs very little interest expense.
In order to calculate the total debt to equity ratio in the credit and leverage statistics section of our analysis we will use the ending balances from our outstanding debt analysis as well as from our shareholders’ equity analysis. Starting in Year 0, we divide Year 0 outstanding debt ending balance by Year 0 shareholders’ equity ending balance. Your formula in cell (P63) should look like the following: =P43/P54
Ratios analysis
Total debt to capital
Total debt to capital is similar to total debt to equity only it is not displayed as a ratio, but rather as a percentage. Total debt to capital shows debt as a percentage of both debt and equity held on our target company’s balance sheet. It also shows the degree to which our target company would be financing its balance sheet with debt. By looking at this statistic we can quickly see the relative degree of leverage our target company would be using under the assumed capital structure. Like total debt to equity, it is an effective statistic for comparing the leverage of a company over time to monitor whether a company is levering up or down its balance sheet.
In order to calculate total debt to capital (Year 0), we will divide the outstanding debt ending balance by the sum of Year 0 outstanding debt ending balance and shareholders’ equity ending balance. Your formula in cell (P64) should look like following: =P43/(P43+P54); in other words:
total debt to capital = outstanding debt (end of year) / [outstanding debt (end of year) + shareholders’ equity (end of year)]
Total debt to EBITDA
Total debt to EBITDA is the next metric we will calculate for the target company. Credit rating agencies often use this statistic to measure the ability of a company to service its debt. A higher debt to EBITDA ratio signals a higher chance of default. This could provide rating agencies reason to lower the credit rating of a company. Total Debt to EBITDA provides a measurement of a company’s ability to pay down its debt and also indicates the approximate amount of time it would take a company to pay down its debt using earnings before interest and tax expense and ignoring non-cash expenses such as depreciation and amortization.
We will calculate total debt to EBITDA for Year 0 by dividing the outstanding debt ending balance (Year 0) by the Year 0 EBITDA figure. Your formula in cell (P57) should look like the following: =P43/E49
Another metric, very similar to our last ratio, is the net debt to EBITDA ratio. We will use this statistic in our ratios analysis to measure how well the target company is positioned to pay down its debt by taking into consideration both its cash on the balance sheet as well as the company’s EBITDA. Credit rating agencies also look at net debt to EBITDA to measure a company’s leverage and risk of default. High ratios indicate a higher risk of default.
We calculate net debt to EBITDA in our analysis for Year 0 by first subtracting cash-on-hand ending balance (Year 0) from the outstanding debt balance at the end of Year 0. That figure is then divided by the EBITDA figure for Year 0. Your formula for net debt to EBITDA (P58) should look like the following: =(P43-P48)/E49; in other words:
net debt to EBITDA = (total outstanding debt - cash on hand) / EBITDA
Coverage Ratios
As part of our leveraged buyout analysis, we want to be certain that the target company can generate enough earnings to at least meet the interest expense that comes along with the new leverage placed on its balance sheet. The EBITDA to interest coverage ratio is a means of drawing some conclusions about the ability to meet interest payments with the company’s EBITDA. An EBITDA to interest expense ratio of at least 1.0x indicates that the company’s EBITDA is large enough to pay off its interest expense obligation. However, this figure does not take into consideration any capital expenditures the company makes, so it is completely within the realm of possibility that a company could have a EBITDA to interest expense ratio greater than 1.0x and not be able to meet its interest expense for a period because money was used towards a capital expenditure.
“We want to be certain that the target company can generate enough earnings to at least meet the interest expense that comes along with the new leverage on its balance sheet.”
Let’s calculate the EBITDA to interest coverage ratio. In Year 0 of our ratios analysis, in order to calculate the EBITDA to interest coverage ratio, we want to divide the Year 0 EBITDA figure by interest expense for Year 0. Note that interest expense is represented as a negative number in our analysis, so in order for this ratio to be represented correctly you will need to have a negative sign in front of one of the inputs in your formula. Your formula for the EBITDA to interest coverage ratio (P60) in Year 0 should look like the following: =E49/-E43
You may wish to keep it in front of interest expense if it helps to keep your thoughts organized, but either way the result will be the same. If you were to omit the negative sign in the formula your result would indicate that EBITDA was negative … and that could cause some issues with the credit ratings agencies!
The final statistic that we will calculate in the ratio analysis portion of our leveraged buyout analysis is the EBIT to interest coverage ratio. This coverage ratio is similar to the previous EBITDA to interest coverage ratio, as it is intended to measure the company’s ability to pay interest expense in a given period. The main difference is that this interest coverage ratio recognizes the accounting costs of depreciation and amortization, whereas the EBITDA coverage ratio is more concerned with measuring ability to pay interest expense from a cash perspective. Both of these interest coverage ratios provide a slightly different insight on the company’s earnings power relative to the cost of debt financing.
In order to calculate the EBIT to interest coverage ratio in Year 0 we will need to divide earnings before interest and tax expense, in this case operating income, of Year 0 by the interest expense of Year 0. Again, we will need to use a negative sign before one of the two inputs in our spreadsheet because interest expense is represented as a negative number in our analysis. Your formula for EBIT to interest coverage should look like the following: =E42/-E43
Both the EBITDA and EBIT interest coverage ratios provide a view into a company’s ability to meet its interest expense obligations. Higher coverage ratios imply a lower risk of default, as earnings are greater than the interest expense owed by the company. While these two coverage ratios are intended to measure the target company’s ability to pay interest expense, they measure it in slightly different ways that help to give a fuller understanding of the target company’s financial situation. Perhaps most importantly, the two ratios differentiate between the ability to pay in real cash terms and non-cash terms.
Ratio analysis helps us to get a more complete understanding of the target company’s financial situation and also identify trends that may not be as readily apparent by simply looking at the financials of a company over a given period of time. We have calculated total debt to equity, total debt to capital, total debt to EBITDA, net debt to EBITDA, as well as coverage ratios EBITDA and EBIT to interest expense – all for Year 0. Let’s use our same calculations and apply them across the explicit forecast range to measure how our credit and leverage statistics will change in relation to our financial forecast for the target company. We do this by highlighting the desired ratio analysis area from Year 0 total debt to equity to Year 5 EBIT to interest coverage. The areas from cell (P39:U46) should now be covered. Let’s apply our ratios across the pro forma forecast period by using the keyboard shortcut CTRL+R. That should fill in the entire ratio analysis portion of our leverage buyout model.
“Ratio analysis provides a deeper understanding and measurement of the financial health of the target company.”
Looking at the results of the ratios analysis, we see that leverage ratios indicate that the debt to equity and debt to capital ratios look to improve over the five-year period. The leverage ratios demonstrate the company is able to lower the amount of debt on its balance sheet relative to equity over the next five years. Similarly, total and net debt to EBITDA ratios also show the size of the target company’s debt steadily shrinking relative to EBITDA in each year. Finally, both coverage ratios indicate that as each year passes the target company will strengthen its ability to pay interest owed. There are no glaring inconsistencies among our ratios and the trend in decreased leverage is consistent with the rest of our analysis. Overall, our ratio analysis provides a deeper understanding and measurement of the financial health of the target company and also helps to more easily identify financial trends about the company.