Debt financing a case study of AMATA power (BIEN HOA) limited

The fourth section analyzes the importance of financial risks relating to debt financing in a foreign currency such as interest rate risk and foreign exchange risk.. The fourth section a

MINISTRY OF EDUCATION AND TRAINING

UNIVERSITY OF ECNOMICS HOCHIMINH CITY

K -

NGUYEN THI THANH THAO

DEBR FINANCING – A CASE STUDY Ò AMATA POWER (BIEN HOA) LIMITED

MASTES’S THESIS

In Banking Ology code: 60.31.12

Supervisor: Dr.TRUONG TAN THANH

Ho Chi Minh City – 2010

ACKNOWLEDGEMENT

The research is completed due to the contribution of many people First of all, I would like to express my deepest gratitude to my supervisor, Dr Truong Tan Thanh, for all he has done for me The thesis could not been finished without his great encouragements and kind helps Again, I would like to extend my sincere appreciation to him

I would like to express my thanks to Dr Nguyen Minh Kieu for his valuable advices He always took care, encouraged and supported us during our course

I acknowledge all instructors at Faculty of Banking Finance and Postgraduate Faculty, University of Economics of Ho Chi Minh for their valuable knowledge

My gratitude is extended to my classmates for their enthusiastic supports in conducting the research, especially Ms Nguyen Thi Kim Dung and Mr Duong Binh Hung

Finally, I sincerely thank my parents and my husband who have always tried their best to help me overcome difficulties during the time of attending the course as well as preparing the thesis

ABSTRACT

The economy has been developing more and more strongly, the competition among firms is fiercer and fiercer In order to run the firm’s business operation in the competitive market, capital is one of necessary elements to speed up the development It likes the blood of the firm There are three financing alternatives to set up the capital which are retained earnings, capital from shareholders and loans from credit institutions The choice of internal or external financing is an extremely vital decision Some of firms like the internal financing (retained earnings, capital from shareholders) due to avoiding the financial risks Some of firms prefer the external financing (loans from credit institutions) due to taking advantages of tax shield and controlling management position However, too much debt can result in increasing dramatically capital costs due to financial distress in terms of increased bankruptcy and agency costs So, the careful consideration to the advantages and disadvantages of each financing resource should be conducted to balance between returns and risks And financial analysis should be done in order to minimize financial risks in case of debt financing

The purpose of this thesis is to evaluate the effectiveness of debt financing process of a defined firm, Amata Power (Bien Hoa) Limited The research is conducted by collecting and analyzing the empirical data in order to understand debt repayment ability as well as the impacts of debt on expenses and profits

TABLE OF CONTENTS

Acknowledgement 1

Abstract 2

Table of contents 3

Abbreviation 6

List of figures 7

List of tables 8

Chapter 1: Introduction 9

1.1 Introduction 9

1.2 Research problem 10

1.3 Methodology 11

1.4 Significance and scope of the study 11

1.5 Structure of the study 12

Chapter 2: Theoretical background 14

2.1 Introduction 14

2.1.1 The Miller and Modigliani theory 14

2.1.2 The trade-off theory 17

2.1.3 The pecking order theory (Myers, 1984) 18

2.2 An overview of debt financing 19

2.3 Financial ability to repay debt 21

2.4 Financial risks of debt financing in a foreign currency 27

2.4.1 Interest rate risk 27

2.4.2 Foreign exchange risk 27

2.5 Conclusion 28

Chapter 3: Research methodology 29

3.1 Introduction 29

3.2 Analysis of debt settlement ability 29

3.2.1 Liquidity 29

3.2.2 Activity 30

3.2.3 Debt management ratios 30

3.2.4 Earnings ratios 31

3.2.5 Profitability measurement ratios 31

3.3 Analysis on financial risks of debt financing in a foreign currency 34

3.3.1 Interest rate risk 34

3.3.2 Foreign exchange risk 34

3.4 Impacts of debt financing on profit 34

3.5 Conclusion 35

Chapter 4: Introduction to Amata Power (Bien Hoa) Limited 37

4.1 An overview of Amata Power (Bien Hoa) Limited 37

4.2 Financial performance 38

4.2.1 Capital structure 38

4.2.2 Business operation 39

4.2.3 Profitability measurement 41

4.2.4 Debt management policy 43

4.3 Recent development and outlook 43

Chapter 5: Analysis on debt financing of Amata Power (Bien Hoa) Ltd 45

5.1 Introduction 45

5.2 An overview of debt financing of APBH 45

5.2.1 Short-term borrowings 45

5.2.2 Long-term borrowings 45

5.3 Analysis on debt settlement ability 48

5.3.1 Debt settlement ability 48

5.3.2 Debt control method 50

5.3.3 Method of cash flow management 52

5.4 Analysis on debt impacts 55

5.4.1 Impact of debt on expenses 55

5.4.2 Risks related to debt in a foreign currency 57

5.4.2.1 Foreign exchange risk 57

5.4.2.2 Interest rate risk 60

5.4.3 Impact of debt on profits 61

5.5 Conclusions 65

Chapter 6: Research conclusion 66

6.1 Summary of study 66

6.2 Implications and recommendations 67

6.3 Future research and limitations 69

Bibliography 70

ABBREVIATION

APBH Amata Power (Bien Hoa) Limited

AP Amata Power Limited

Amata VN Amata Viet Nam Joint Stock Company

BP Banpu Public Company Limited

BIDV Bank for Investment and Development of Vietnam

DEG Deutsche Investitions - Und Entwicklungsgesellschaft MBH EBIT Earnings before interest and tax

KfW Kreditanstalt fur Wiederaufbau

ROA Return on assets

ROE Return on equity

ROIC Return on invested capital

ROS Return on sales

TIE ratio Times-Interest-Earned ratio

VCB Bank for Foreign Trade of Vietnam (Vietcombank)

LIST OF FIGURES

Figure 2.1: Effect of leverage on the value of a firm’s stock 18

Figure 2.2: Liquidity analysis 25

Figure 2.3: Analysis on debt repayment ability 26

Figure 4.1: Structure of shareholders of APBH as of December 31, 2009 39

Figure 4.2: Growth of assets and resources of APBH from 2005 to 2009 40

Figure 4.3: Growth of revenue and profit/loss of APBH from 2005 to 2009 41

Figure 4.4: Profitability ratios of APBH from 2002 to 2009 41

Figure 4.5: Profitability of APBH from 2004 to 2009 42

Figure 5.1: Liquidity ratios of APBH from 2002 to 2009 48

Figure 5.2: Growth of current assets and current liabilities 50

Figure 5.3: Debt management ratios of APBH from 2002 to 2009 51

Figure 5.4: Earnings coverage ratios of APBH from 2002 to 2009 52

Figure 5.5: Cash conversion cycle of APBH from 2002 to 2009 53

Figure 5.6: The cash conversion cycle model in 2009 54

Figure 5.7: Assets – equity turnover of APBH from 2002 to 2009 55

Figure 5.8: Financial expenses of APBH from 2008 to 2010 56

Figure 5.9: Impact of debt on expenses of APBH from 2002 to 2009 57

Figure 5.10: Interest rate risk of APBH from 2005 to 2009 60

LIST OF TABLES

Table 2.1: Summary of financial ratios from the lending viewpoint 22

Table 2.2: Summary of financial ratios from the investors’ viewpoint 23

Table 2.3: Financial ratios combining ratio analysis with cash-flow analysis 24

Table 2.4: Foreign exchange risk of Pha Lai Thermal Power JSC 28

Table 3.1: Financial analysis of APBH from 2002 to 2009 33

Table 4.1: Capital Structure of APBH as of December 31, 2009 39

Table 4.2: Growth of assets and resources of APBH from 2005 to 2009 40

Table 4.3: Growth of revenue and profit/loss of APBH from 2005 to 2009 40

Table 4.4: Profitability ratios of APBH from 2002 to 2009 41

Table 4.5: Comparison ROE and free-risk interest rate 42

Table 5.1: Loan disbursement and repayment schedule of APBH 47

Table 5.2: Liquidity ratios of APBH from 2002 to 2009 48

Table 5.3: Growth of current assets and current liabilities 50

Table 5.4: Debt management ratios of APBH from 2002 to 2009 50

Table 5.5: Earnings coverage ratios of APBH from 2002 to 2009 51

Table 5.6: Activity ratios of APBH from 2002 to 2009 52

Table 5.7: Assets – equity turnover ratios of APBH from 2002 to 2009 55

Table 5.8: Costs structure of APBH from 2008 to 2010 56

Table 5.9: Impact of debt on expenses of APBH from 2002 to 2009 57

Table 5.10: Foreign exchange rate (USD/VND) on settlement date to creditors 59

Table 5.11: Interest rate of creditors and two banks in Vietnam 60

Table 5.12: Comparison with firm in the same industry in 2009 62

Table 5.13: Components of return on equity for APBH 62

Table 5.14: Extended Dupont System Analysis for APBH: 2002-2009 63

CHAPTER 1 INTRODUCTION

1.1 INTRODUCTION

The globalization has brought countries together and made countries integrate deeply into the world Nowadays the economic competitiveness does not limit in the national border, it has extended to the international market The capital

is means to create favourable conditions for the successful business Most firms prefer the capital mobilization from debt There are many kinds of debt which are bank loans, sponsor loans, bonds, and account payable

In comparison with equity, debt is cheaper and has more tax advantages In the upturn, using leverage helps companies to maximize their profit But in the downturn, the debt management becomes more difficult Facing with huge debts, only a little downtrend can lead to insolvency Borrowing to run business is not wrong, but too much debt is problematic

Brigham and Ehrhardt (2002, p.619) also indicated that debt has two important advantages First, the interest paid is a tax deduction, which lowers debt’s effective cost Second, debt holders get a fixed return, so stockholders do not have

to share the profits if the business is extremely successful However, debt also has disadvantages as following: First of all, the higher the debt ratio, the riskier the company, hence the higher its cost of both debt and equity Secondly, if a company falls on hard times and operating income is not sufficient to cover interest charges, its stockholders will have to make up the shortfall, and if they cannot, bankruptcy will result

In this thesis, debt financing in form of loans from credit institutions and parent companies is mainly discussed In order to get bank loans and sponsor loans, the company needs to demonstrate its financial solidity to its bankers by the financial analysis The goal of analysis is to assess an obligor from a financial

perspective to confirm that company will be able to meet its obligations when they are due, to identify the potential risks, and to perfect the security and collateral and loan documentations in order to optimally manage these inherent risks (Andrew Fight, 2004, p.104)

Besides financial analysis is a tool which is used to evaluate company’s business operation which is volatile or stable in order to define the level of debt financing

1.2 RESEARCH PROBLEM

Amata Power (Bien Hoa) Ltd (named briefly as APBH) is a joint-venture company of which the capital comes from Thai, Swiss and Vietnamese parties APBH has produced and supplied power to all customers in Amata industrial park APBH’s capital is made up of contributed capital from shareholders and debts in form of bank loans and sponsor loans from other foreign companies

APBH is a suitable choice to conduct this study Because one of factors influencing debt financing in form of bank loans is ability to receive bank loans, APBH is a manufacturing company which has many fixed assets that can serve as securities for bank loans Besides APBH obtains loan guarantees from the parent company, Amata Power Limited in Thailand APBH has high sale stability because

it does business in monopoly sector

Determining the optimal amount of debt is a complicated process Many researches in this area are conducted, but yet there is no optimal combination of debt and equity for firms to apply This study makes no effort in trying to solve this issue, but it will discuss some specific research questions as follows:

• How good are the firm’s financial abilities to settle debt?

• How does debt financing impact on profit?

The purpose of this study is to evaluate financial abilities of the firm to meet its short- and long-term debt obligations and the effects of debt on profit in order to assess the effectiveness of debt financing process

1.3 METHODOLOGY

A case study is conducted at APBH by the quantitative approach The secondary data is retrieved from annual auditing reports and loan dossier of the firm The data is collected from Y2002 to Y2009

1.4 SIGNIFICANCE AND SCOPE OF THE STUDY

Efficient debt management is an extremely difficult problem It requires the leaders have talent management skills and exact estimations One of recent typical examples for bad debt management is the Vinashin case “Vinashin fell into financial trouble in 2008 when the global economic meltdown started The main reason was the weak management of group’s leaders Currently, Vinashin’s total debts are $4.5 billion, while total assets are $5.4 billion” (Ninh Kieu, 2010, p.3) To help Vinashin avoid bankruptcy, the government has a restructuring plan and provides an initial $131.5 million financial bailout to complete unfinished shipbuilding projects (Nhu Ngoc, 2010) First of all, the government has restructured the group’s board, and then forced Vinashin to focus on core businesses like shipbuilding, ship-repairing and shipbuilding-related industries The lesson of Vinashin indicates that borrowing is a small issue, but how to manage debt efficiently is a complex problem

APBH is a joint venture company Its capital is not only equity from shareholders but also debt from foreign banks It is a typical firm with high debt ratio, but the efficiency of debt financing has not been evaluated properly, no one has evaluated it before The purpose of this study is to evaluate the efficiency of debt financing of the company in order to have the right decision on capital in the future when starting a new project

Due to a specific case study, the research results from case analysis may not

be generalized and applied to all other firms Ratios should be compared with the aggregate economy, its industry or industries, its major or competitors within the industry

1.5 STRUCTURE OF THE STUDY

Chapter 1: Introduction to the study

This chapter gives an overview of the study Firstly, it begins with an introduction to research background Secondly, it explains more research problem through research questions and research objectives Thirdly, it makes clear applicable research method to the study Fourthly, it presents the reasons why the subject is chosen and its limitation Finally, it ends with the outline of study

Chapter 2: Theoretical background

This chapter will present theoretical framework relating to debt financing It consists of five sections The first section begins with the outline of the chapter and reviews three previous capital structure theories which are the Miller and Modigliani theory, the trade-off theory, the pecking order theory The second section introduces an overview of debt financing and some factors influencing the debt financing decision The third section discusses a firm’s financial ability to meet its short- and long-term obligations The fourth section analyzes the importance of financial risks relating to debt financing in a foreign currency such as interest rate risk and foreign exchange risk The fifth section provides some conclusions to this chapter

Chapter 3: Research methodology

This chapter discusses the research methodology which has been used to test hypotheses It includes five parts The first part introduces structure of the chapter The second part presents the method for analyzing the financial ability to repay debt The third part focuses on the ways to determine financial risks of debt financing in a foreign currency The fourth part clarifies impacts of debt financing

on profits The last part ends with some conclusions

Chapter 4: Introduction to Amata Power (Bien Hoa) Limited

This chapter provides an overview of Amata Power (Bien Hoa) Ltd from the beginning of establishing the firm until now The first section explains the reasons why Amata Power (Bien Hoa) Ltd is set up and located at Amata industrial park as

well as the development phases of power plant The second section summarizes some main points of finance The third section introduces the developments of power plant in the near future

Chapter 5: Analysis on debt financing of Amata Power (Bien Hoa) Limited

This chapter focuses on applying the theory to make clear two research questions It includes five sections The first section introduces the outline of the chapter The second section summarizes an overview of debt financing of APBH The third section presents debt repayment ability of APBH The fourth section analyses the impacts of debt on expenses and profits The last section draws some findings from the practical analysis

Chapter 6: Research Conclusion

This chapter will draw conclusions from the data analysis, recommendations

as well as the limitation of the study The first section summarizes the conclusion of the research The second section presents the implication of the study and some recommendations The last section ends with the limitation of the study

CHAPTER 2 THEORETICAL BACKGROUND

2.1 INTRODUCTION

This chapter will present theoretical framework relating to debt financing It consists of five sections The first section begins with the outline of the chapter and reviews three previous capital structure theories which are the Miller and Modigliani theory, the trade-off theory, the pecking order theory The second section introduces an overview of debt financing and some factors influencing the debt financing decision The third section discusses a firm’s financial ability to meet its short- and long-term obligations The fourth section analyzes the importance of financial risks relating to debt financing in a foreign currency such as interest rate risk and foreign exchange risk The fifth section provides some conclusions to this chapter

Capital structure is a financial complex issue and causes many debates Franco Modigliani and Merton Miller presented their theory on capital structure as

an original generally accepted theory Although the Miller and Modigliani theories with a number of non-realistic assumptions do not provide a realistic description of how firms should set up their capital structure, it is a theoretical framework to evolvement of later theories which are the trade-off theory and the pecking order theory

2.1.1 The Miller and Modigliani Theory

Brigham and Ehrhardt (2002, p.642) emphasized the Miller and Modigliani theory as a modern capital structure theory

In 1958, Franco Modigliani and Merton Miller published a financial article

in which a firm’s value is unaffected by its capital structure with a number of assumptions as follows: (1) There are no brokerage costs (2) There are no taxes (3) There are no bankruptcy costs (4) Investors can borrow at the same rate as

corporations (5) All investors have the same information as management about the firm’s future investment opportunities (6) EBIT is not affected by the use of debt

In 1963, Franco Modigliani and Merton Miller published a follow-up article

in which they relaxed the assumption that there are no corporate taxes Interest payments are deductible as the expenses, but dividend payments to shareholders are not deductible This conclusion encourages firms to use a high level of debt financing due to the benefits of attracting a tax shield

Several years later, Merton Miller modified their theory that returns on stocks are taxed at lower effective rates than returns on debt in accordance with the effects of personal taxes That leads to favor the use of equity financing

Ross, Westerfield and Jaffe (2005, p.418, 426) summarized the Miller and Modigliani theory as follows:

Summary of Modigliani-Miller Propositions without Taxes

Homemade leverage means if levered firm are priced too high, rational investors will simply borrow on their personal accounts to buy shares in unlevered firms Where

VL is the value of levered firm

VU is the value of unlevered firm

rS is the expected return on equity or stock, also callled the cost of equity or the required return on equity

rB is the interest rate, also called the cost of debt

r0 is the cost of capital for an all-equity firm

B is the value of the firm’s debt or bonds

S is the value of the firm’s stock or equity

Summary of Modigliani-Miller Propositions with Corporate Taxes

2.1.2 The Trade-Off Theory

Brigham and Ehrhardt (2002, p.644) stated that in practice bankruptcy can be quite costly Firms in bankruptcy have very high legal and accounting expenses, and they also have a hard time retaining customers, suppliers, and employees Moreover, bankruptcy often forces a firm to liquidate or sell assets for less than they would be worth if the firm were to continue operating

Bankruptcy-related problems are most likely arisen when a firm includes a great deal of debt in its capital structure Therefore, bankruptcy costs discourage firms from pushing their use of debt to excessive level

The preceding arguments led to the development of what is called “the off theory of leverage” in which firms trade off the benefits of debt financing (favorable corporate tax treatment) against the higher interest rates and bankruptcy cost

trade-The trade-off theory presents the optimal capital structure in which marginal tax shelter benefits equal to marginal bankruptcy-related costs through the use of debt financing

2.1.3 The Pecking Order Theory (Myers, 1984)

The pecking order theory is from Myers (1984) It states that if a firm issues equity, investors will infer that the stock is overvalued They will not buy it until the stock price has fallen enough to eliminate any disadvantage from equity issuance The result is that no one will issue equity

Suppose there are three sources of funding available to firms: retained earnings, debt, and equity Retained earnings have no any adverse selection problem, equity is subject to serious adverse selection problem while debt has only

MM Result incorporating the Effects of Corporate Taxation: Price of the stock if there were no bankruptcy-related costs

Value of

stock

Value reduced by bankruptcy-related costs

Actual price of stock

Value of stock if the firm used no financial leverage

Threshold debt level

where bankruptcy

costs become material

Optimal capital structure:

Marginal tax shelter benefits = Marginal bankruptcy-related costs

Figure 2.1: Effect of leverage on the value of a firm’s stock

Value added by debt tax shelter benefits

Source: Financial management, Brigham, E.F and Ehrhardt M.C (2002)

a minor adverse selection problem From that point of view, equity is strictly riskier than debt The theory states that the firms prefer internal resources to external resources First, the firms choose retained earnings from previous years to finance their projects Second, if firms do not possess enough internal capital, they will take loans from credit institutions Third, if firms do not have enough ability to receive a bank loan, they will issue new shares Benefits of internal financing are cheaper transactions costs and maintaining the shareholders’ control of their business

There are two rules of the pecking order:

• Rule 1: Use internal financing

• Rule 2: Issue the safest securities first

2.2 AN OVERVIEW OF DEBT FINANCING

Debt financing is defined that is financing a company by selling the bonds, notes or mortgages held by the business Basically it is borrowing money to keep the business running Long term debt financing is typically associated with larger assets such as buildings, equipments, land, and large machinery The schedule for repayment for long term debt financing spends for more than a year Short term debt financing is mostly associated with operations of the business such as inventory purchasing, payroll, and supplies The repayment of short term debt financing happens in less than a year With debt financing, the business does not have to give

up future profits or ownership in the company like with equity financing [1]

Ross, Westerfield and Jaffe (2005) referred debt financing in terms of benefit from the viewpoints of owners as well as creditors, and emphasized that financial leverage is related to the extent to which a firm that relies on debt financing rather than equity There are three implications of debt financing: (1) By raising funds through debt, stockholders can maintain control of a firm without increasing their investment (2) Creditors look to the equity, or owner-supplied funds, to provide a margin of safety, so the higher the proportion of total capital provided by stockholders, the less the risk faced by creditors (3) If the firm earns more on

[1] http://www.businessfinance.com/debt-financing.htm

investments financed with borrowed funds than it pays in interest, the return of the owners’ capital is magnified, or “leveraged”

The use of debt “leverages up” the expected rate of return on equity in normal conditions There are two reasons for the leveraging effect: (1) Because interest is a deductible expense, the use of debt lowers the tax bill and leaves more

of the firm’s operating income available to its investors (2) If operating income as a percentage of assets exceeds the interest rate on debt, as it generally does, then firm can use debt to acquire assets, pay the interest on the debt, and have something left over as a “bonus” for its stockholders However, financial leverage can cut both ways in recessions If sales are lower and costs are higher than were expected, the return on assets will also be lower than was expected The leveraged firm’s return

on equity falls especially sharply, and losses occur (Brigham and Ehrhardt, 2002, p.82) To use debt effectively, firms consider balancing higher expected returns against increased risks

There are twelve factors influencing the debt financing decisions as follows (Brigham and Ehrhardt, 2002):

• Sales Stability - A firm whose sales are relatively stable can safely take on

more debt and incur higher fixed charges than a company with unstable sales

• Asset Structure - Firms whose assets are suitable as security for loans tend

to use debt rather heavily

• Operating Leverage - A firm with less operating leverage is better able to

employ financial leverage because it will have less business risk

• Growth Rate - Other things the same, faster-growing firms must rely more

heavily on external capital However, firms often face greater uncertainty, which tends to reduce their willingness to use debt

• Profitability - The high rates of return enable firms to do most of their

financing with internally generated funds

• Taxes - A major reason for using debt is that interest is deductible, which

lowers the effective cost of debt However, if most of a firm’s income is already sheltered from taxes by depreciation tax shields, by interest on currently outstanding debt, or by tax loss carry-forwards, its tax rate will be low, so additional debt will not be as advantageous as it would be to firm

with higher effective tax rate

• Control - The effect of debt versus stock on a management’s control

position can influence capital structure

• Management Attitudes - Some aggressive managers have a tendency to use

debt in an effort to boost profits, whereas managers tend to be more conservative than others, and thus use less debt than average firm in their industry

• Lender and Rating Agency Attitudes - Regardless of managers’ own

analyses of the proper leverage factors for their firms, lenders’ and rating agencies’ attitudes frequently influence debt financing decisions

• Market Conditions - Conditions in the stock and bond markets undergo

both long- and short-run changes that can have an important bearing on a firm’s optimal capital structure

• The Firm’s Internal Condition - A firm’s own internal condition can also

have a bearing on its target capital structure due to information asymmetry

• Financial Flexibility - Financial flexibility is the ability to raise capital on

reasonable terms under adverse conditions

2.3 FINANCIAL ABILITY TO REPAY DEBT

From the bankers’ and investors’ viewpoint, Andrew Fight (2004) conducted study of the debt financing through ratio analysis The goal of analysis is to evaluate

a firm’s financial abilities to meet its obligations as well as identify the potential risks There is no “standard set” of ratios It depends on the nature of the firm and what risks the firm may be facing

Although the reputation of ratio analysis is a retrospective diagnostic system,

it has also evolved and also has its uses It is useful in analyzing trends by comparing year on year statistics It can help form an overall picture of the firm’s situation It can provide useful clues as to the state of a company’s health It can help in assessing a firm’s profitability and financial structure It can assist in perfecting security arrangements to enhance the lending bank’s ability to manage the loan and call in the loan for repayment

From the lending viewpoint, there are four categories of financial ratios in order to making loan granting decisions, such as liquidity management ratios, asset management ratios, capital structure ratios, and profitability ratios

Table 2.1: Summary of financial ratios from the lending viewpoint

Categories of ratios Meaning of ratios

1 Liquidity measurement ratios

Current ratio To assess ability to meet its short-term obligations

Quick ratio To evaluate ability to pay firm’s debt at short notice

2 Asset management ratios

Debtors to sales To indicate the period of credit given to customers

Stock turnover To compare cost of goods sold with the investment in stock

3 Capital structure ratios

Gearing ratio To assess the relationship between the borrowings and the

equity Interest cover To evaluate the margin of profitability to meet the interest

repayments on debt Dividend cover To compare profits generated and dividend payable

4 Profitability measurement ratios

Profit margin To show the management’s use of the resources under its

control Return on capital employed To identify amount the firm is earning on the capital that is

invested in it Source: Credit risk management, Andrew Fight (2004)

From the investors’ viewpoint, there are three groups of financial ratios to measure the performance of the firm, its financial standing, and return on

investment

Table 2.2: Summary of financial ratios from the investors’ viewpoint

1 Performance ratios - to measure how well a firm is controlling expenses and managing assets to produce sales and profit

• Profitability performance measurements: return on capital employed, return on equity, profit margin

• Asset performance measurements: net asset turnover, fixed asset turnover, working capital ratio, stock turnover, debtor turnover, creditor turnover

2 Financial standing ratios – to examine levels of debt in relation to both assets and other equity

as well as ability to repay debt

• Short-term liquidity measurements: current ratio, quick ratio

• Long-term solvency measurement: gearing ratio, interest cover ratio

3 Investment ratios – to measure the performance of the investment and to assess the likely future performance

• Dividend cover

• Earnings per share (EPS)

• Price/earnings (P/E) ratio

Source: Credit risk management, Andrew Fight (2004)

Besides the benefits of ratio analysis, Andrew Fight (2004) also pointed out its limitations as follows:

• Publicly available information is often not sufficiently detailed and out of date

• Each firm may have adopted different accounting policies and adjustments

• It is very difficult to establish the performance of any one firm within the group through consolidated accounts

• The figures stated in the accounts may be untypical for the rest of the year

• “Window dressing” the balance sheet at year end is not uncommon

• There should always be a logical relationship between the numerator and the denominator, which should both be measured consistently and on the same basis as any comparative ratio

• The possible effects of inflation and general economic conditions tend to be cyclical in comparing ratios over time

• When comparing one firm’s ratios to another’s, the second firm should be similar both in terms of the industry sector, size and technology

• A ratio should always be interpreted in the full context of the firm’s affairs

To minimize the above limitations, Reilly and Brown (2006) conducted ratio analysis in combination with cash-flow analysis to assess the debt repayment and financial risks relating to the firm

Table 2.3: Financial ratios combining ratio analysis with cash-flow analysis

1 Internal liquidity ratios: current ratio, quick ratio, cash ratio, receivables turnover, inventory turnover, payables turnover

2 Operating performance

• Operating efficiency ratios: total asset turnover, net fixed asset turnover, equity turnover

• Operating profitability ratios: profit margin, return on total invested capital, return on equity

3 Proportion of debt (balance sheet ratio) – indicate what proportion of the firm’s capital is derived from debt compared to other sources of capital

• Debt - equity ratio

• Long-term debt - total capital ratio

• Total debt – total capital ratio

4 Earnings and cash flow coverage ratios – indicate the flow of earnings or cash flows available to meet the required interest and lease payments; and cash flow to a firm’s outstanding debt

• Interest coverage ratio

• Fixed financial cost coverage

• Cash flow coverage ratio

• Cash flow – long-term debt ratio

• Cash flow – total debt ratio

Source: Investment analysis and portfolio management, Frank K Reilly and Keith C.Brown (2006)

In Vietnam, Nguyen Thi Ngoc Trang and Nguyen Thi Lien Hoa (2007) evaluated the debt financing through analyzing a firm’s liquidity, and capital structure as well as earnings power to repay debt It includes two sections: (1) Liquidity analysis and (2) Debt settlement analysis

The aim of liquidity analysis is to evaluate the importance of liquidity and the ability to meet short-term liabilities In case of lack of liquidity, the firm can not take advantages of preferential discounts or opportunities to make more margins, may lead to sell assets or investment projects Illiquidity may forecast lower returns, less business chances, and losing the shareholder’s control

Analysis of a firm’s debt settlement is absolutely different from liquidity analysis In liquidity analysis, analytical period is enough short to exactly forecast cash flow Debt repayment analysis uses less accurate ratios, but they are more

Liquidity of

working capital business cycle Liquidity of Some items measuring additional liquidity

Stock turnover Debtor turnover Creditor turnover

Current asset structure Quick ratio

Cash-flow measurement Financial flexibility Discussion and analysis of management (MD&A) Case analysis

Liquidity analysis

Figure 2.2: Liquidity analysis

Source: Phan tich tai chinh, Nguyen Thi Ngoc Trang & Nguyen Thi Lien Hoa (2007) Current ratio

Cash ratios

comprehensive Analysis of debt repayment is relating to analyze the capital structure and earnings power

A basic risk of levered firm is not having enough cash when facing unfavourable conditions Some fixed expenses can be deferred, but expenses relating to debt cannot be deferred although the payment may take disadvantages to shareholders The debt ratio is higher, the insolvency ability in financial distress and decrease in earnings are larger One of the limitations of capital structure analysis does not focus on cash flow to repay interest and principal So earnings power analysis is necessary to minimize this limitation

Capital structure and insolvency ability Earnings power

Fixed charge coverage Interest coverage Cash-flow to fixed charge ratio

Analysis of debt repayment ability

Figure 2.3: Analysis on debt repayment ability

Assessing capital structure

• Total debt - total capital ratio

• Total debt - equity ratio

• Long-term debt - equity ratio

Measuring insolvency ability in

accordance with assets

Source: Phan tich tai chinh, Nguyen Thi Ngoc Trang & Nguyen Thi Lien Hoa (2007)

2.4 FINANCIAL RISKS OF DEBT FINANCING IN A FOREIGN CURRENCY

Three above studies are not only used to assess financial ability of the firm in case of debt financing but also identify the potential financial risks Reilly and Brown (2006) defined that financial risk is the additional uncertainty of returns to equity holders due to a firm’s use of fixed financial obligation securities As a firm increases its relative debt financing with contractual obligations, it increase its financial risk and the possibility of default and bankruptcy

Besides, Nguyen Minh Kieu (2008) modified two kinds of financial risk relating to debt financing in a foreign currency which are interest rate risk and foreign exchange risk

2.4.1 Interest rate risk

Interest rate risk is the risk caused by interest rate changes This risk often arises in the credit relationship of multinational companies, credit institutions, big companies that have loans with floating interest rates If a company borrows with floating interest rate, when market interest rate increases, cost of capital will increase On the contrary, if the company lends or invests with floating rate, when the market rate goes down, interest earning of the company will go down Interest rate risk is especially important when mobilizing capital through issuing bonds, or financial investment with large amount and for long time

2.4.2 Foreign exchange risk

Foreign exchange risk is the risk caused by moving foreign exchange rate that affects expected value in the future Foreign exchange risk may occur in many different activities of the company But in general any activity that the inflows are

in a currency and the outflows are in another currency is in danger of risk when the exchange rate changes

The foreign exchange risk is really a huge burden to firms operate from loan capital in a foreign currency One of the typical firms facing this risk is PhaLai Thermal Power Joint Stock Company The firm is financed JPY48,359,483,797 by

Electricity of Vietnam from Official Development Assistance of Japanese Government to build Phalai power plant 2 in 2002 The exchange rate between JPY and VND has moved upward during last years

Table 2.4: Foreign exchange risk of Pha Lai Thermal Power JSC

Depreciation of VND compared with JPY (%)

5.56 34.93 4.64 Provision due to the depreciation of VND (VND billion)

232.57 1,543.12 540.65 Source: Analysis report on Pha Lai Thermal Power JSC of Artex securities JSC (2009)

Financial ability of the firm is examined in accordance with analyzing financial statements and comparing year on year There are main five groups of financial ratios which are liquidity ratios, activity ratios, profitability ratios, debt management ratios, earnings ratios

Besides the normal financial risks due to using excessive debt, there are two kinds of financial risk with a loan in a foreign currency The risks are caused by the fluctuations in floating interest rate and foreign exchange rate

CHAPTER 3 RESEARCH METHODOLOGY

3.1 INTRODUCTION

This chapter discusses the research methodology which has been used to test hypotheses It includes five parts The first part introduces structure of the chapter The second part presents the method for analyzing the financial ability to repay debt The third part focuses on the ways to determine financial risks of debt financing in a foreign currency The fourth part clarifies impacts of debt financing

on profits The last part ends with some conclusions

3.2 ANALYSIS OF DEBT SETTLEMENT ABILITY

Amata Power (Bien Hoa) Limited is a joint-venture company in which capital comes from equity and debt All loans are borrowed from foreign banks and parent companies In accordance with the nature of the firm, analysis of financial ability to meet its obligations is conducted as follows:

• Data is collected from annual audited financial statements of latest eight years (Y2002 to Y2009) and loan agreements

• Calculating the financial ratios of APBH from Y2002 to Y2009 There are five groups of financial ratios: liquidity ratios, activity ratios, debt management ratios, earnings ratios, and profitability measurement ratios

• Comparing the financial ratios year on year statistics is to forecast the trends

of firm to repay debt and define potential financial risks

3.2.1 Liquidity

Liquidity is a firm’s ability to meet its short-run obligations and is often associated with net working capital, the difference between current assets and current liabilities To the extent the firm has sufficient cash flow, it will be able to avoid defaulting on its financial obligations, and avoid experiencing financial

distress There are three kinds of ratio to measure liquidity which are current ratio, quick ratio and cash ratio If a firm is having financial difficulties, it may not be able to pay its bills on time or it may need to extend its bank credit Current liabilities may rise faster than current assets and these ratios may fall This may be the first sign of financial trouble (Ross, Westerfield and Jaffe, 2005, p.34)

3.2.2 Activity

A high current ratio does not ensure that a firm will have the cash required to meet its needs If inventories can not be sold, or if receivables can not be collected

in a timely manner, then the apparent safety reflected in a high current ratio could

be illusory A cycle in which firms purchase inventory, sell goods on credit, and then collect accounts receivable is referred to as the cash conversion cycle Working capital policy is designed to minimize the time between cash expenditures on materials and the collection of cash on sales (Brigham and Ehrhardt, 2002, p.841)

(1) Inventory conversion period – the average time required to convert materials

into finished goods and then to sell those goods

(2) Receivables collection period – the average length of time required to convert the firm’s receivables into cash DSO refers to days sales outstanding

(3) Payables deferral period - the average length of time between the purchase of

materials and labor and the payment of cash for them

(4) Cash conversion cycle - the length of time between the firm’s actual cash

expenditures and its own cash receipts

+

Receivablescollection period (2)

-Payables deferral period (3)

In order to assess the firm’s activity, Ross, Westerfield and Jaffe (2005, p.35) modified two ratios which are fixed assets turnover ratio and total assets turnover ratio They are used to measure how effectively the firm’s assets are being managed

or how effectively assets used to generate sales

3.2.3 Debt management ratios

Ross, Westerfield and Jaffe (2005, p.36) considered that measures of financial leverage are tools in determining the probability that the firm will default

on its debt contracts Too much debt can lead to higher probability of insolvency and financial distress Debt ratios provide information about protection of creditors from insolvency and the ability of firms to obtain additional financing for potentially attractive investment opportunities There are three ratios which are debt ratio, debt-to-equity ratio and equity multiplier

• EBITDA Coverage Ratio – Ability to pay debt

Brigham and Ehrhardt (2002, p.83) emphasizes the TIE ratio is useful for assessing a firm’s ability to meet interest charges on its debt, but this ratio has two shortcomings: (1) Interest is not the only fixed financial charges – companies must also reduce debt on schedule, and many firms lease assets and thus must make lease payments If they fail to repay debt or meet lease payments, they can be forced into bankruptcy (2) EBIT does not represent all the cash flow available to service debt, especially if a firm has high depreciation and/or amortization charges To account for these deficiencies, EBITDA coverage ratio should be considered

3.2.5 Profitability measurement ratios

Ross, Westerfield and Jaffe (2005, p.38) proposed three methods to measure profitability including profit margin or return on sales, return on assets, and return

on equity

• Profit margin (Return on Sales – ROS)

Profit margins express profit as a percentage of total operating revenue Profit margins reflect the firm’s ability to produce a product or service at a low cost

or high price

• Return on assets (ROA)

One common measure of managerial performance is the ratio of income to average total assets, both before tax and after tax

• Return on equity (ROE)

This ratio is defined as net income (after interest and taxes) divided by average stockholders’ equity

To measure profitability, Reilly and Brown (2006, p.319) supplemented the return on total invested capital (ROIC) which relates the firm’s earning to all the invested capital involved in the enterprise (debt, preferred stock, and common stock) While there might be a tendency to equate total capital with total assets, most analysts differentiate due to the term “invested capital”, which does not include non-interest-bearing liabilities such as trade accounts payable, accrued expenses, income taxes payables, and deferred income taxes In contrast, short-term debt such as bank borrowings and principal payments due on long-term debt are interest bearing and would be included as invested capital

Table 3.1: Financial analysis of APBH from 2002 to 2009

1 Liquidity

- Quick ratio (Current assets–Inventories)/Current liabilities

- Cash ratio (Cash+Marketable securities)/Current

Total assets turnover

3 Debt management ratio

- Debt ratio Total debt/Total assets

- Debt-to-equity

- Equity multiplier Total assets/Total equity

4 Earnings coverage ratio

- Interest coverage Earnings before interest and taxes (EBIT)/

Debt interest charges

- EBITDA coverage

ratio

EBITDA and lease payments/

(Interest+Principal payment+Lease payment)

5 Profitability measurement ratios

- Profit margin (Return on sales - ROS)

+ Net ROS Net income/Total operating revenue

+ Gross ROS EBIT/Total operating revenue

- Return on assets (ROA)

+ Net ROA Net income/Total assets

+ Gross ROA EBIT/Total assets

Source: Corporate finance, Ross, S.A., Westerfield, R W and Jaffe, J (2005); Financial

management, Brigham, E.F and Ehrhardt M.C (2002); Investment analysis and portfolio

management, Frank K Reilly and Keith C.Brown (2006)

3.3 ANALYSIS ON FINANCIAL RISKS OF DEBT FINANCING IN A FOREIGN CURRENCY

3.3.1 Interest rate risk

Comparing interest rate of DEG, KfW, Amata Power Limited and Banpu on each settlement date with interest rate of two big banks in Vietnam, VCB-Vietcombank and BIDV-Bank for Investment and Development of Vietnam, in the same period in order to identify the interest rate risk

3.3.2 Foreign exchange risk

Let Xn-1 is the foreign exchange rate of the (n-1)th payment

Xn is the foreign exchange rate of the nth payment

∆Xn is the proportion of difference in foreign exchange rate between two payments to the foreign exchange rate of the (n-1)th payment ∆Xi can be calculated

The traditional Dupont system and the extended Dupont system are used to

make clear the influence of debt on profit First of all, broking down ROE of APBH

into three parts is conducted to find out how each section impacts on APBH’s return

from 2002 to 2009

ROE = Net profit margin x Total assets turnover x Financial leverage multiplier

The equation shows that an increase in each of these components can lead to

the increase in return

The extended Dupont system is to provide additional insights into the effect

of financial leverage on the firm, namely pinpoint the effect of interest expenses and

income taxes on APBH’s ROE The extended model begins with EBIT (Reilly and

Brown, 2006, p.322):

3.5 CONCLUSION

This chapter summarizes the research methodology to examine two research

questions Data is mainly retrieved from the financial statements of APBH from

2002 to 2009 and other documents relating to the loans

ROE

Operating profit margin X

Total assets turnover -

Interest expense rate X

Financial leverage multiplier X

Tax retention rate

=

Return

on assets -

Interest expense rate X

Financial leverage multiplier X

Tax retention rate

=

X

Financial leverage multiplier X

Tax retention rate

=

Earnings before tax Common equity