With lending rates gradually coming down in Zambia, Premier companies at the epilogue of their 2017 financial year will be asking themselves the question: Did we manage our short term and long term liabilities well? The importance of credit analysis can never be understated. It is the evaluation of a company from the perspective of the holder or potential holders of its debt such as the banks, stock market in the case of listed bonds, and other lenders. Key to the purpose of credit analysis is the ability to predict whether or not a company will face financial distress.
We conducted a study of the 2016 performance of a handful of companies on LuSE. We compared their acid test and gearing. The former measures a company’s ability to settle obligations as they fall due (with in the year). The latter measures the company’s indebtedness against equity.
The reason why companies find debt financing attractive is because it offers corporate interest tax shields and management incentives for value creation. Tax shields provide for the provision of corporate tax being deducted off interest paid on debt. However, even with tax shields, management are under pressure to generate cash flows to meet the obligations of interest and principal payments.
The allure for debt is massive for companies with serious capex projects. As evidenced in the chart, Zambia Sugar’s gearing was high due to the syndicated loan they got for project PAAR. Zanaco came in second as it too had a major upgrade of its computer system and a noted strategy implementation project. CEC came in third because it is domicile in the energy industry that is capital intensive.
However, there is a cost to debt. Management teams will know that the moment they pen down a decision to go for debt, they must also assess the costs of debt. Some of them include legal costs or implications of finding themselves in financial distress. In addition, the management team will be aware that once they make the commitment, they will foregone other attractive investment opportunities due to their commitment. Lastly, debt may also cause conflict between creditors and shareholders. If the company faces financial distress, panic stations hit shareholders who will fear that the debt may be serviced through a slice of shareholder equity.