University of Chicago
Type of paper: Thesis/Dissertation Chapter
Financial ratios: How to use financial ratios to maximise value and success for your business
Capital structure is basically the combination of equity and debt that a firm uses to finance its operations (Damodaran, 2005). Capital structure normally refers to the debt-to-equity ratio of a firm. This basically provides how risky a firm is hence a firm that is financed by more debt poses greater risk as it is relatively highly leveraged. For this reason, firms should strive to employ an optimal capital structure which is the best debt-to-equity ratio that actually maximizes its value. A company’s optimal capital structure is one that minimizes its cost of capital and offers a balance between the company’s ideal debt-to-equity ranges (Damodaran, 2005).
Nature of businesses in brief
EBay (NASDAQ: EBAY)
eBay Inc. is basically a global leader in commerce and payments which actually provide a robust platform particularly for merchants of all sizes where they can compete and win. It connects millions of sellers and buyers and in2013 it enabled a commerce volume of $212 billion. It is one of the largest online market places in the world hence allowing users to sell and buy through PayPal in nearly every country on earth. Through PayPal, eBay actually enables businesses and individuals to quickly, securely and easily receive and send digital payments. It also has eBay Enterprise which usually enables multichannel retailing, omnichannel commerce and digital marketing for global businesses and enterprises basically in the US and also internationally (eBay Inc., 2012).
The Clorox Company (NYSE: CLX)
The Clorox Company deals in the manufacturing and marketing of rofessional and consumer products worldwide. Its cleaning segment offers laundry additives such as bleach products. The company’s household segment provides wraps, plastic bags, and containers. Its lifestyle segment offers dressings and sauces, water filters and filtration systems and finally natural personal care products. The company’s products are primarily sold through warehouse clubs, mass merchandisers, distributors, grocery stores, medical supply providers, other retail outlet and direct sales force (The Clorox Company, 2012).
Alaska Air Group Inc. (NYSE: ALK)
This is a holding company for Horizon Air and Alaska Airlines and it is based in SeaTac, Washington. It is a carrier that basically collectively server almost over 90 destination in Mexico, Canada and the United States (Alaska Air Group, Inc., 2012).
Through its subsidiaries, Alaska Air Group provides cargo and passengers’ air transportation services operating through Alaska regional and Alaska Mainline segments serving approximately 100 cities (Alaska Air Group, Inc., 2012).
Total current assets and long-term asset
eBay has a total current assets of $ 23, 283,000,000 in 2013 and a total long term assets of $ 18,205,000,000. In the same year, The Clorox Company had a total current asset value of $1.42 billion and a total long term asset value of $2.89 billion while Alaska Airline Group had a total current asset value of $1.762 billion and a total long-term asset value of $4.076 billion.
Total current liabilities and long-term liabilities
eBay has a total current liabilities of $ 12,639,000,000 in 2013 and a total long term liabilities of $ 5,202,000,000. In the same year (2013), The Clorox Company had a total current liabilities value of $1.13 billion and a total long term liabilities value of $3.04 billion while Alaska Airline Group had a total current liabilities value of $1.58 billion and a total long-term liabilities value of $2.23 billion.
In 2013, eBay had revenue of $16.047 billion; the revenue of The Clorox Company was $5.62 billion while that of Alaska Airline Group was $5.156 billion.
Total debt/equity ratios
This ratio shows how well company’s creditors are protected if the company is insolvent. It is computed by dividing the company’s total debt (total liabilities) by its total equity. It is basically a measure that shows a firm’s financial leverage (Bull, 2008).
eBay: debt-equity ratio= 17841/23647= 0.7545
The Clorox Company: debt-equity ratio=4170/146= 28.56
Alaska Airline Group: debt-equity ratio=3809/2029= 1.877
Generally, lower debt-to-equity ratio values are favorable because they indicate less risk. However, higher values of the debt-to-equity ratio shows that the company uses more of external finance hence it is very risky particularly when the interest rates are high (Kapil, 2011). From the computations above, it is evident that eBay is less risky because it has a ratio of less than 1.00 hence uses less debt than equity financing. Alaska Airline Group and The Clorox Company have a ratio of more than 1.00 implying that most of their assets are financed by debt. However, The Clorox Company is highly risky in case it has higher interest rates because it uses more of debt financing compared to equity financing. A debt-to-equity ratio of 26.56 is very high for any given company (Bull, 2008).
Profit margin, returns on assets, and return on equity ratios of all three companies
Profit margin= net income/net sales (Kapil, 2011).
Return on assets=net income/ total assets (Bull, 2008).
Return on equity=net income/equity (Kapil, 2011).
eBay The Clorox Company Alaska Airline Group
Profit margin 2856/16,047
= 17.80% 574/5620
Return of assets 2856/41,488
Return on equity 2856/23,647
The three companies have the following betas
The Clorox Company: 0.47
Alaska Airline Group: 1.1
Alaska Airline Group has a higher beta implying that it is the most risky company among the three. EBay has a relatively higher value hence relatively riskier while The Clorox Company is less risky among the three companies (Kapil, 2011).
The advantages and disadvantages of debt over equity financing
Debt financing has the following advantages over equity financing (Peavler, 2012):
By using debt financing, a firm has control over the destiny of the business. The company is accountable and answerable to itself, make all decisions regarding the business alone and is entitled to all the profit.
Interest payable on the debt or loan is usually tax deductible hence shielding a part of the business income from the taxes thus lowering the company’s tax liability every accounting period (Peavler, 2012).
The lender does not share in the company’s profits unlike in equity financing where part of it is distributed in the form of dividend. A company just needs to make its loan repayment in a timely manner (Bull, 2008).
A company can actually apply for loans that have more favorable terms to the business.
Debt financing has the following disadvantages over equity financing (Peavler, 2012):
Debt financing usually requires a company to make large loan repayments hence lowering amount of finance at its exposure. And any default in repayment may ruin its credit rating hence limiting its future borrowing (Peavler, 2012).
Failure to repay loans from family and friends on time strains those relationships.
In case personal assets are pledged, one may lose then if they default in repayments.
Debt financing is prone to the risk of bankruptcy. More debts increase the risk of bankruptcy (Peavler, 2012).
Recommendation of the best capital structure
An optimal capital structure is the best debt-to-equity ratio that actually maximizes its value. A company’s optimal capital structure is one that minimizes its cost of capital and offers a balance between the company’s ideal debt-to-equity ranges. In determining the optimal capital structure, we need to calculate the weighted average cost of capital of each company in order to determine that proportion that minimizes cost of capital.
In regards to the above debt-to-equity values, eBay should have a capital structure of 50% debt and 50% equity. This will ensure a balance between the company’s ideal debt-to-equity ranges hence maximizing the value of the company. The Clorox Company, on the other hand should have a capital structure of 40% debt and 60% equity so that it can minimize its cost of capital thus assisting in value maximization. This will ensure that its high debt-to-equity value is reduced to a value of close to 1.00 in order to maximize its value. Finally, Alaska Airline Group should have a capital structure of 48.75% debt and 51.25% equity. This will ensure a balance between the company’s ideal debt-to-equity ranges hence maximizing the value of the company.
Alaska Air Group, Inc. (2012). Investor relations. Retrieved May 2012 fromhttp://phx.corporate-ir.net/phoenix.zhtml?c=109361&p=irol-IRHome
Bull, R. (2008). Financial ratios: How to use financial ratios to maximise value and success for your business. Amsterdam: Elsevier/CIMA Pub.
Damodaran, A. (2005). Finding the right financing mix: The capital structure decision. Retrieved May 2012 fromhttp://pages.stern.nyu.edu/~adamodar/pdfiles/cfovhds/capstr.pdf
Ebay Inc. (2012). Investor relations. Retrieved May 2012 from http://investor.ebay.com
Kapil, S. (2011). Financial management. Noida, India: Pearson.
Peavler, R. (2012). Debt and equity financing. Retrieved May 2012 fromhttp://bizfinance.about.com/od/generalinformatio1/a/debtequityfin.htm
The Clorox Company (2012). Investors. Retrieved May 2012 fromhttp://investors.thecloroxcompany.com/