Financial leverage

Debt-like customer advances and DCF valuation

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Oracle Corporation says it will use customer advance payments to enhance cash flow and mitigate the amount of debt required to finance its AI infrastructure investment. We think investors should consider whether this, and other components of net working capital, are in-substance debt financing and adjust their analysis accordingly.

The standard approach of treating working capital as operating assets and liabilities for DCF valuation may not always be the best. In an interactive model, we demonstrate how receivables and payables (and similar working capital items) can be treated as financing items in an enterprise free cash flow DCF valuation.

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Receivables, payables and (hidden) financial leverage

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When analysing receivables and payables the focus of investors tends to be on their cash flow and liquidity effects. However, these balances also impact financial leverage and equity risk, which may affect the comparability of valuation metrics. Factoring and other working capital financing contributes to the problem, but all companies are potentially affected.

We explain the leverage effects of receivables and payables, and use two European Auto Parts companies to demonstrate how equity valuation metrics can be adjusted to provide additional analytical insights. We also consider how the accounting for working capital balances and financing arrangements complicates the analysis.

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Relative valuation conflicts – EV/EBITDA versus P/E

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There is usually at least one metric that gives valuation-based support for an investment, even if this is contradicted by other indicators of relative or absolute value. You may have heard comments such as “… but it looks cheap on EV/EBITDA” to help justify a particular investment recommendation.

We examine why different multiples can give conflicting indications of relative value. For example, food-on-the-go stock Greggs trades at a 35% discount to rival Dominos Pizza, based on EV/EBITDA, but at a 24% premium using a price earnings ratio. Which multiple (if either) gives the correct relative valuation?

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Analysing complex capital structures – perpetual bonds

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Many companies look beyond straight debt and ordinary shares when raising finance, with capital structures increasingly including an array of complex financial instruments. This presents challenges for investors, particularly when analysing performance and leverage.

We investigate the effects of one form of ‘hybrid’ financing – perpetual super-subordinated bonds – where securities with debt-like features may be reported as equity in financial statements. Recent proposals by the IASB to improve transparency in reporting these instruments and other complex capital structures will help investors.

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DCF Valuation: Financial leverage and the debt tax shield

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DCF valuation models can either be based on free cash flow attributable to equity investors or the free cash flow available for all providers of finance. Each requires a different approach to allowing for financial leverage, including adjustments to beta and recognition of the debt interest tax shield.   

We present an interactive DCF model that illustrates discounted equity cash flow and discounted enterprise cash flow using both the WACC and APV methods. Understanding each approach helps in ensuring consistent valuations, whichever method you choose to adopt.

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Equity beta, asset beta and financial leverage

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It can be observed that higher financial leverage increases equity beta. However, the relationship between the unleveraged asset or enterprise beta (the beta of the underlying operating business), and leveraged equity beta that is commonly applied in practice, is incomplete.

We explain the relevance of asset betas in equity valuation and why it is important to analyse the beta of debt finance and the value, and riskiness, of the debt interest tax shield when delevering and relevering equity beta.

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Valuing the debt interest tax shield

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The fact that the cost of debt finance is tax deductible, whereas the cost of equity is not, seems to give a structural advantage to debt finance. The value (if any) of this ‘tax shield’ is either an explicit or more likely implicit component of any equity valuation.

The most commonly quoted calculation of the value of the debt interest tax shield understates value by ignoring growth but, potentially, overstates value by ignoring the effect of personal taxes. We explain how to incorporate these often-ignored factors in your analysis.

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New supplier finance disclosures will affect operating cash flow

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Reported operating cash flow, leverage and net working capital measures, may be misleading if a company engages in supply chain financing. The impact can be significant but, at present, calculating the effect and making adjustments is difficult. Additional IFRS disclosures proposed by the IASB will help.

We explain the new disclosures and provide an interactive model to illustrate how to use them to calculate more realistic measures of cash flow, leverage and working capital. The adjustments depend on whether liabilities are classified as trade payables or debt finance and may require the inclusion of a non-cash ‘effective’ operating cash outflow.

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Convertible accounting: New US GAAP inflates earnings

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Changes to convertible bond accounting under US GAAP will mean higher reported debt but, paradoxically, a lower (and sometimes zero) interest expense. In our view, the resulting increase in earnings is artificial, fails to faithfully represent the cost of convertible financing and will not benefit investors.

The recent surge in convertible issuance, and the use of so-called convertible bond hedges, may have more to do with favourable accounting than favourable economics. We use the recent convertible issue by Twitter to illustrate the revised US GAAP and compare this with the more realistic approach under IFRS.

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Sale and leaseback: Operating risks and reporting anomalies

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It is important to consider the impact of different leasing structures on operational risk, in addition to financial leverage. Leases with variable payments reduce operating risk, but sale and leaseback transactions may have the opposite effect. We use hotel company International Hotels Group and airline EasyJet to illustrate.

IFRS accounting for leases with variable payments and for sale and leaseback transactions is clear. However, combining the two in one transaction is more problematic. The IASB’s recently proposed amendment to IFRS 16 would bring leases with variable payments arising from sale and leaseback transactions onto the balance sheet. We explain why we disagree.

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Pension leverage under IFRS and US GAAP

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US GAAP and IFRS present the effects of pension leverage differently in financial statements, notably leverage arising from pension fund asset allocation. This complicates the comparison and interpretation of performance measures and valuation multiples.

We use Delta Air Lines to illustrate the positive impact of the US GAAP ‘expected return’ approach on reported profit, including the effect of optimistic return assumptions. If Delta had applied the IFRS ‘net interest’ approach we estimate that a ‘gain’ of $594m would have been excluded from profit and loss and instead reported in OCI.

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Allocating value: An option-based approach

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You might assume that a change in enterprise value completely accrues to equity investors; however, this is often not the case. Other claims, such as debt or equity warrants, also change in value as enterprise value changes. Understanding this effect can be important when analysing many companies, especially those in financial distress.

Option-like characteristics of debt and equity claims drive the allocation of changes in enterprise value between debt and equity investors. We apply an interactive model to analyse recent changes in the enterprise value of Air France–KLM.

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Leasing and leverage – credit rating agencies disagree

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Rating agency Fitch recently announced its approach to dealing with the new lease accounting in its credit metrics. Their approach is at odds with that already published by Moody’s and Standard & Poor’s. Of particular interest is the way the rating agencies deal with the differences between IFRS and US GAAP.

We explain the different approaches of the rating agencies, how we think investors should calculate key metrics, such as leverage and cash flow, and the importance of considering the impact of leasing on operating leverage and business flexibility.

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Leverage and cash flow effects of supply chain finance

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Supply chain finance, such as factoring and reverse factoring, are often labelled as tools used by companies in financial distress. Although we believe they are valid financing techniques, the reporting of these arrangements can affect leverage and cash flow. Due to poor disclosure you may not even know about it. 

Debt finance may not appear as debt in the balance sheet.  Operating cash flows may not include payments for some operating expenses or may be distorted by changes in financing being classified as operating. We explain how supply chain finance works and how you may need to adjust key metrics.

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