Ch.12 Detailed Study Notes on Corporate Finance, Debt, and Profitability Ratios

Companies issue stock to raise equity, and also take loans for funding.
Important decision: How much equity to offer and how much debt to incur.
- Balance between equity and debt impacts financial health.

Calculation indicates the relationship between a company's total debt and total equity.
Example Values:
- Company A: Debt to Equity Ratio = $2.31
- Nike: Debt to Equity Ratio = $2.89
- Meaning: Debt is 289% greater than the equity.
Healthy ratios are crucial:
- Standard acceptable ranges, above which companies approach bankruptcy (into 300% - 400% range).
Risks of High Debt:
- More debt incurs more interest payments, increasing financial burden.
- Historical Example: Netflix faced challenges with high debt levels.

Companies evaluate expenses related to acquiring funds:
- Long-term debt might incur a cost of about 6%-7%.
- Equity might incur a similar percentage cost (dividends).
Weighted Average Cost of Capital (WACC):
- Combines costs of debt and equity to determine overall capital cost.
- Investment or project decisions must exceed WACC for profitability.

Every business proposal must demonstrate exceeding WACC to be viable.
- Competing proposals require justification of expected profits over capital costs.
Importance of trends in the debt to equity ratio over time:
- Rising ratio implies dependency on borrowing, indicating potential financial distress.

Types of loans:
- Individual loans (car loans, mortgages): Payments reduce principal and cover interest.
- Corporate loans typically involve only interest payments for extended periods (interest-only loans).
Corporate Loan Specifics:
- Includes conditions such as debt covenants requiring regular financial reporting (e.g., times interest earned, current asset ratio).

Corporate banks reassess financial status frequently;
- Financial health metrics monitored regularly.
Events like bank failures (e.g., Silicon Valley Bank) highlight risks:
- Potentially catastrophic implications if covenants are violated; requires rapid refinancing efforts.
FDIC Insurance:
- Individual accounts insured up to $250,000, raising concerns for larger businesses.
- Strategies like laddered CDs mitigate risk across multiple banks.

Banks generate revenue through loan activity by leveraging deposits (can lend 9-10 times deposits).
Securitization: Turning loans into investment products, complicating liquidity and exposure of banks in crises.
- Derivatives and interest rate swaps used for risk management.

Times Interest Earned (TIE) Ratio Formula:
- $TIE = \frac{Net Income + Interest Expense + Income Tax Expense}{Interest Expense}$
- Example:
- Nike’s TIE = 20
- VF Corporation's TIE = 8.9
Higher TIE indicates better ability to cover interest expenses (servicing debt).

Profitability as a critical area of concern in financial assessments:
- Investors focus primarily on earnings per share (EPS) – how much profit is allocated per share of stock.
- Communicated metrics include revenue growth, net income growth, and EPS:
- Strong EPS growth signals investor confidence.
Profit Margins:
- Gross profit ratio calculated as:
- $Gross Profit Ratio = \frac{Gross Profit}{Net Sales}$
- Example: VF Corporation has a gross profit margin of 55%. This indicates that for every dollar of sales after costs, 55 cents is profit (not including operating expenses).

Nike example of profit margin:
- Approximately 6% profit margin, sustained through high volume sales despite lower margin.
Grocery store economics:
- Complex supply chains lead to pressures on pricing and profitability due to perishability and high markup chains (manufacturer to wholesaler to retailer).
- Managing inventory is crucial to minimize losses from spoilage, affecting net earnings significantly.

Understanding financial structures, ratios, and corporate debt can define a company's potential for growth and risk. Proper financial management is essential for sustainability and success.