SUPERFUND FINANCIAL ASSESSMENT SYSTEM Technical Support Document Prepared for Economic Analysis Division Office of Policy and Resource Management U.S. Environmental Protection Agency Prepared by Industrial Economics, Incorporated 30 Boylston Street Cambridge, Massachusetts 02138 25 May 1982 ------- SUPERFUND FINANCIAL ASSESSMENT SYSTEM TECHNICAL SUPPORT DOCUMENT Prepared for ECONOMIC ANALYSIS DIVISION OFFICE OF POLICY AND RESOURCE MANAGEMENT U.S. ENVIRONMENTAL PROTECTION AGENCY Prepared by INDUSTRIAL ECONOMICS, INCORPORATED 30 BOYLSTON STREET CAMBRIDGE, MASSACHUSETTS 02138 25 May 1982 ------- TABLE OF CONTENTS CHAPTER 1: EXECUTIVE SUMMARY 1 Background 1 The Superfund Financial Assessment System 2 Limitations to the Analysis 6 Organization of the Report 7 CHAPTER 2: DEFINING ABILITY TO PAY 8 Introduction 8 Defining the Threshold 8 Measuring the Threshold 10 Inappropriate Measures of Ability to Pay 12 CHAPTER 3: CALCULATING ABILITY TO PAY 14 Introduction 14 Ability to Pay Methodology 15 Step 1: Future Cash Flows 15 Step 2: Sustaining Investment 16 Step 3: Residual Cash Flow 20 Step 4: Variability of Cash Flow 21 Step 5:« Conversion to Before-Tax Dollars 25 Interpretation of the Results 27 CHAPTER 4: FINANCIAL RATIOS 29 Cash Flow to Total Debt 30 Total Debt to Equity 33 Interest Coverage Ratio 34 Interpretation of All Three Ratios 35 APPENDIX A NORMAL DISTRIBUTION 37 Introduction 37 Characteristics of the Normal Distribution 37 ------- LIST OF EXHIBITS EXHIBIT 1-1 AFFORDABLE REMEDIAL ACTION COSTS 4 EXHIBIT 1-2 FINANCIAL RATIOS 5 EXHIBIT 3-1 FACTORS USED IN COMPUTING WEIGHTED AVERAGE CASH FLOWS 17 EXHIBIT 3-2 RATIO OF DEPRECIATION AT CURRENT COST TO HISTORICAL COST DEPRECIATION 19 EXHIBIT 3-3 SAMPLE CALCULATION OF WEIGHTED AVERAGE RESIDUAL CASH FLOW 22 EXHIBIT 3-4 CALCULATING THE STANDARD DEVIATION OF THE RESIDUAL CASH FLOW 24 EXHIBIT 3-5 VALUES FROM THE CUMULATIVE NORMAL DISTRIBUTION 26 EXHIBIT 3-6 AFFORDABLE REMEDIAL ACTION COSTS 28 EXHIBIT 4-1 SUMMARY OF THE FINANCIAL RATIOS 31 EXHIBIT A-l NORMAL PROBABILITY DISTRIBUTION 38 EXHIBIT A-2 CUMULATIVE PROBABILITY DISTRIBUTION 40 ------- EXECUTIVE SUMMARY CHAPTER 1 BACKGROUND In December 1980 Congress passed the Comprehensive En- vironmental Response, Compensation, and Liability Act (com- monly called the Superfund Act) which created a fund to provide remedial action for abandoned waste sites which pose a direct threat to human health, welfare or the environment. Under the Superfund Act, the government can (1) compel pri- vate parties to assume the responsibility for the costs of remedial action at the site,-*- or (2) finance remedial action directly through the Hazardous Substance Response Trust Fund. Because the likely cost of remedial action at the abandoned sites far exceeds the capabilities for the Fund, EPA has chosen to compel responsible private parties to pay these costs whenever possible. In some cases, the responsible party claims that it cannot afford to pay the full cost of remedial action. In the past this claim has led to a lengthy negotiation process to determine the portion of the costs the party can afford "^EPA can compel responsible parties to undertake remedial action or to reimburse the Fund for monies spent on remedial action. ------- -2- to pay. To assist Superfund enforcement personnel in this negotiation process, a method of estimating the amount a firm can pay has been devised and this method has been com- puterized to make it more accessible and easier to use. THE SUPERFUND FINANCIAL ASSESSMENT SYSTEM The Superfund Financial Assessment System is designed to: 1) Calculate the amount of remedial action costs a firm can afford to pay, and 2) Provide a concise financial evaluation of the firm. To accomplish these aims, a two-part system has been developed. The first part of the system calculates the firm's "ability to pay." This part of the system measures the cash flows from the firm's operations and the variabil- ity in these cash flows to determine the ability of the firm to continue to maintain its current business and to pay the remedial action costs. The system determines the cash available to fund remedial action by estimating the cash flow generated by the firm's operations less the cash which must be reinvested in the business to maintain its plant and equipment. The expected value and the variability of this "residual" cash flow is calculated. The system then provides a table which indicates the probability that a given amount of cash will be available to fund remedial action. -'-The Instruction Manual accompanying this document explains how this computerized system works. ^Note that this test only considers the funds needed to main- tain the current business. It does not allow the firm a reprieve from paying remedial action costs in order to pro- vide funds to expand current businesses or to enter into new businesses^ ------- -3- Exhibit 1-1 provides an example of the ability to pay results. This exhibit indicates that there is a 50 percent probability that the firm will be able to pay remedial ac- tion costs totaling $308.3 million each year or a one-time charge of $1,106.8 million. The one-time charge assumes that the firm can borrow against its future expected earnings. In some cases--if the firm already has a large amount of debt or if the firm's earnings are too low relative to its current interest pay- ments—further borrowing by the firm may not be possible. The second part of the Superfund Financial Assessment System uses three standard financial ratios to assess whether ad- ditional borrowing by the firm may be feasible.1 The pur- pose of this part of the system is to alert enforcement personnel to possible financial problems the firm is ex- periencing. In some cases, these ratios will indicate the presence of a short-term financial problem (for example, low earnings in the most recent fiscal year). Failure of the ratios alone is not necessarily sufficient reason to excuse the firm from its obligation to pay remedial action costs. Instead, it may indicate that the firm is unable to finance the remedial action expenditures as they are in- curred and that an extended payment schedule may be nec- essary. Similarly, if the ratios indicate no serious financial problems currently exist, this does not guarantee that the firm can afford to pay remedial action costs. Instead this may indicate that the firm's liabilities are small in rela- tion to the cash flow generated by operations; but that the cash flow is still inadequate to allow the firm to maintain its current operations. An example of the results from the second part of the system is provided in Exhibit 1-2. As this exhibit shows, the firm "passes" all of the ratios indicating that the firm is unlikely to be experiencing any serious financial dif- ficulties. A more detailed discussion of these ratios is provided in Chapter 4. 1-The three ratios examined are: (1) cash flow to total debt, (2) total debt to equity, and (3) the interest coverage ratio. In some cases, the firm may use one or more of these ratios to argue that they are unable to pay the full cost of remedial action. ------- Exhibit 1-1 AFFORDABLE REMEDIAL ACTION COSTS 5/1/82 case: test case #1 PARTY: PFIZER, INCORPORATED location: new york, new york region: 2 date filed: 4/1/82 PROBABILITY OF ADEQUATE CASH FLOW ANNUAL COSTS affordable < BEFORE-TAX) ONE-TIME CHARGE AFFORDABLE (BEFORE-TAX) 507. 6071 70 V. 80'/. 90"/. 9 5Y. 997. 308, 29G, 283. 287, 248, 30 18 15 90 78 229.37 196.65 HOG.78 1063.21 1016.52 981.75 885.9G 823.43 705.96 THIS MEANS THAT THERE IS A 99 PERCENT CHANCE THAT PFIZER, INCORPORATED WILL BE ABLE TO AFFORD 196.65 DOLLARS ANNUALLY OR A ONE-TIME CHARGE OF 705.96 DOLLARS (ASSUMING THE FIRM WILL BE ABLE TO BORROW AGAINST FUTURE EXPECTED EARNINGS). REMEMBER THIS CALCULATION ALLOWS FOR SUFFICIENT FUNDS TO MAINTAIN THEIR CURRENT PLANT AND EQUIPMENT BUT WILL NOT ALLOW THE FIRM TO MAKE ANY SIZABLE NEW INVESTMENTS. ------- Exhibit 1-2 FINANCIAL RATIOS THE PROGRAM WILL NOW CALCULATE SOME COMMON FINANCIAL RATIOS TO DETERMINE THE ABILITY OF THE FIRM TO FINANCE ANY LARGE INITIAL EXPENDITURES WHICH MAY BE REQUIRED. THE RATIO OF CASH FLOW TO TOTAL LIABILITIES FOR PFIZER, INCORPORATED 0.205 THIS RATIO IS ABOVE THE CRITICAL LEVEL INDICATING THAT THE FIRM IS UNLIKELY TO GO BANKRUPT IN THE NEAR FUTURE. THE RATIO OF TOTAL LIABILITIES TO NET WORTH FOR PFIZER, INCORPORATED 1 .057 THIS RATIO IS BELOW THE CRITICAL LEVEL INDICATING THAT THE FIRM SHOULD BE ABLE TO MEET ITS FUTURE OBLIGATIONS. THE INTEREST COVERAGE RATIO FOR PFIZER, INCORPORATED IS 4.358 THIS RATIO IS ABOVE THE CRITICAL LEVEL INDICATING THAT THE FIRM HAS ADEQUATE INCOME TO MEET ITS SHORT-TERM OBLIGATIONS. ------- -6- LIMITATIONS TO THE ANALYSIS The user of the financial assessment system should be aware of the assumptions underlying the calculations and the limitations of the analysis. There are three major limitations of the analysis. These are discussed below. First, the system relies on historical data. To the extent that past historical financial conditions are known not to be representative of the future due to dramatic changes in market conditions, or actions on the part of the firm such as mergers, acquisitions or plant closures, the system will produce inaccurate results. In these cases, the analyst may need to obtain forecasts of the firm's future financial condition. The system does, however, give greater weight to the most recent years when calculating the firm's ability to pay remedial action costs. If these years are more re- flective of the future, the use of historical data will pose fewer problems. If the recent years are known to be less accurate, the analyst may eliminate the more recent years from the analysis. Second, the method used in this analysis has been sim- plified in order to be able to computerize the method and to ensure its applicability to a wide range of firms. As a result of this simplicity, the results are not likely to be as accurate as those produced by a detailed financial analysis of each firm. The ratios, for example, are not perfect indicators of a firm's financial viability. As discussed in Chapter 4, the literature on bankruptcy indicates that sample firms have been misclassified on the basis of these ratios.^ An attempt was made to select the more successful ratios, but no ratio will predict financial difficulties flawlessly. Finally, in some instances, neither the ability to pay calculation nor the ratios will be applicable. If the firm l"Misclassified" implies that firms which later proved viable were classified as likely candidates for bankruptcy and con- versely, firms which later went bankrupt were classified as viable. ------- -7- is regulated to the extent that the majority of its revenues are determined by rates established by an independent entity (for example, a public utilities commission), the viability of the firm and the firm's ability to pay remedial action costs will be determined by the rate setting entity and will not depend on normal market forces. ORGANIZATION OF THIS REPORT The remainder of the technical support document is or- ganized as follows: Chapter 2 reviews the concepts of ability to pay and financial viability. Chapter 3 describes the calculation of the ability to pay remedial action costs. Chapter 4 explains the selection of the three financial ratios and discusses the interpreta- tion of the results of these ratios. Appendix A explains the use of the normal dis- tribution- for calculating the probability the firm will be able to afford a given level of remedial action costs. The accompanyinq document, the Instruction Manual, pro- vides the analyst with step-by-step instructions on the use of the system and the data required, and a brief overview of the interpretation of the results. ------- DEFINING ABILITY TO PAY CHAPTER 2 INTRODUCTION There are two key decisions which must be made when assessing a firm's "ability to pay." First, at what point is a firm judged unable to pay any additional costs? Is this the point at which the firm goes bankrupt, the point at which the firm cannot continue its operations at their current level, or some other point? In short, EPA must de- cide what burden they are willing to impose upon the firm. Second, once the point at which the firm is unable to pay has been defined, the ability to pay methodology must measure the funds which can be withdrawn from the business before the firm reaches this threshold. Each of these com- ponents of the methodology are discussed below. The final section describes some common measures which should not be used to assess ability to pay. DEFINING THE THRESHOLD EPA has used a variety of measures of a firm's ability to pay threshold in the past. Two common measures—insol- vency and economic viability—are frequently used. The first measure assesses the firm's ability to meet its current ob- ligations (payroll, interest payments, principal repayments ------- -9- and so forth). The imposition of additional costs on a firm which is experiencing difficulty meeting these current obligations may cause the firm to become insolvent. The second measure commonly used computes the reduc- tion in profitability which results from the additional costs and determines whether or not the firm is econom- ically better off liquidating all or part of the business rather than continuing to operate. If this is the case, the firm's economic viability is judged to be threatened. EPA's "threatened plant" studies often use this second measure as the determinant of ability to pay. In the case of remedial action costs, the firm cannot avoid these costs by threatening to shut down a part of its operations. Thus, the firm's economic viability is not relevant. It is the first measure--the firm's solven- cy—that is of importance here. Insolvency occurs whenever the firm is unable to meet its cash obligations. At this point the firm may file for bankruptcy and EPA will have to file a claim against the company to recover remedial action costs. The bankruptcy court will then decide upon the priority of EPA's claim. In this event EPA may have to wait a substantial period of time to recover its claim and may receive only a portion of the total claim. To avoid costly delays in recovering the claim, it was assumed that forcing the firm to the brink of insolvency is an undesirable threshold to adopt when judging the firm's ability to pay. The threshold adopted for this analysis is one which would allow the firm to maintain its ongoing bus- inesses. The analysis therefore allows the firm sufficient cash to reinvest to maintain their current plant and equip- ment. This level of cash should allow the firm to remain in business indefinitely but would not provide the resources for expansion or new investment. -*-The firm could of course choose to invest in new businesses rather than maintain its current businesses. The firm may be choosing this course in order to maximize the return to its shareholders. The system does not take this into ac- count as the firm's strategic decisions are not of concern here. ------- -10- MEASURING THE THRESHOLD After defining the threshold as the point at which the firm can maintain its current operations but cannot expand or invest in new businesses, a methodology must be deter- mined which enables the analyst to measure this point. The amount a firm can afford to pay can be defined as the max- imum amount of additional costs which the firm can incur without jeopardizing its ability to continue as an ongoing business. To measure the point at which this threshold is reached the cash flows generated by the business should be compared to the cash flows needed to maintain the business. If the business generates cash in excess of that needed to maintain the business, the firm could incur additional costs without threatening the solvency of the company or the viability of the business. As all capital budgeting texts point out, it is the cash flows which determine the value of an investment. One of the most important tasks in capital budgeting is estimating future cash flows for a project...The reason we express the benefits expected to be derived from a project in terms of cash flows rather than in terms of income is that cash is what is central to all decisions of the firm. The firm invests now in the hope of receiving cash returns in a greater amount in the fu- ture. Only cash receipts can be reinvested in the firm or paid to stockholders in the form of dividends.1 A sale on account is an economic event recorded by the accountant and affecting accounting income. However, the firm has not yet received the cash, it cannot spend the cash, and the ultimate collection of the cash is still uncertain. For the purposes -*-James C. VanHorne, Financial Management and Policy, Third Edition, Prentice Hall, Inc., Englewood Cliffs, New Jersey, 1974, p. 67. ------- -11- of investment analysis we are more inter- ested in the moment when the cash is re- ceived . 1 Thus, cash flow is the appropriate metric to measure the additional costs a firm can afford to pay. To measure the firm's ability to pay, estimates of the following are required: • The future cash flows generated by the firm's ongoing operations, • The cash reinvestment needed to sustain the firm's ongoing operations, and • The variability in the cash generated by the business. The cash flows generated by the firm's business and the sus- taining reinvestment required are needed to calculate the residual cash flow available for paying remedial action costs. The variability of this residual cash flow is also important. Cash flow from operations can vary tremendously due to ec- onomic cycles, the competitive market, and other factors, and will depend to a large degree upon the industry and the firm's position within the industry. Variability of the cash flows increases the uncertainty that a given amount of cash will be available to the business at any point in time. Since the amount of available cash at any point in time is less certain, the payment of a fixed amount of remedial action costs may cause financial difficulties. All other things being equal, the more variable the firm's cash flow, the less likely it will be able to pay a given level of remedial action costs. To summarize the above discussion, an appropriate measure of ability to pay should include the following char- acteristics : ^Harold Bierman, Jr. and Seymour Smidt, The Capital Budget- ing Decision, Fourth Edition, Macmillan Publishing Co., Inc., New York, New York, 1975, p. 114. ------- -12- • It should rely on cash flows as the appropriate metric. • It should measure the expected future value of the firm's cash flows from operations less the cash needed to sustain its operations. • It should measure the variability in the expected future cash flows to de- termine how likely it is that the firm will be able to bear a given level of remedial action costs. The ability to pay methodology developed takes into account each of these features. Chapter 3 describes precisely how this is done. INAPPROPRIATE MEASURES OF ABILITY TO PAY As there is sometimes confusion regarding the measuring of a firm's ability to pay, it is useful to also discuss what measures should not be used to assess ability to pay.^ First, a firm's ability to pay cannot be determined by the amount of cash or cash equivalents (marketable securities) the firm shows on its most recent financial statements. The firm's cash measures its current liquidity and ignores the firm's ability to generate funds from its ongoing oper- ations. Generally, the cash on the firm's balance sheet will be too restrictive a view of the firm's ability to pay. Second, the net worth of the firm is not an appropri- ate measure of the firm's ability to pay. This figure rep- resents the contribution of the shareholders over the life of the firm and, as such, bears little relation to the current market value of the shareholders' equity investment. Third, the market value of the stock generally is not a good measure of ability to pay. The market value of the 1-Much of the following discussion is taken from a memorandum from Robert L. Hayes to Michael Richardson, EPA, entitled "The Ability of Firms to Pay Civic Penalties," 3 April 1978. ------- -13- firm's common stock in theory reflects the market's expec- tations of the future value of the shareholder's invest- ment. However, the market value of the stock is only a good indication of the future earnings of the firm if the stock is publicly-owned and widely traded. A fourth commonly suggested measure of ability to pay— the firm's annual income—is also not an appropriate yard- stick for assessing the costs a firm can afford. As ex- plained above, it is the cash flows which determine the value of an investment and not the income shown on a firm's finan- cial statements. ------- CALCULATING ABILITY TO PAY CHAPTER 3 INTRODUCTION The main purpose of the financial assessment system is to estimate the amount the firm can afford to pay for re- medial action. Chapter 2 reviewed the key characteristics an ability to pay analysis should have. • It should be based on the cash flows of the firm. • It should consider the cash flows from operations less the cash needed to maintain the business. • It should consider,the variability of the cash flows of the firm. In designing the ability to pay methodology two other factors were considered. First, the data for calculating a firm's ability to pay must be readily obtainable. This implies that the system cannot rely on the firm's pro forma estimates of their future expected earnings since in most cases EPA will not have access to these estimates. Therefore, the system was designed to rely on readily ob- tainable historical financial information. Second, the calculations must be routine and not rely heavily on judgment so that the system can be mechanized. ------- -15- This implies that the calculations must be based on figures which can be taken directly from the firm's financial statements and should not rely on an analyst's judgment of how to adjust these figures for inflation or for future economic and market conditions. This chapter reviews how the ability to pay methodol- ogy was designed to include these characteristics. The interpretation of the results provided by the financial assessment system is then discussed. ABILITY TO PAY METHODOLOGY The system was designed to calculate ability to pay in the following manner. Step 1: Estimate future annual cash flows from operations. Step 2: Calculate the reinvestment needed to sustain future operations. Step 3: Calculate the residual cash flow available for remedial action costs. Step 4: Compute the variability of the re- sidual cash flow. Step 5: Express affordable annual amounts in before-tax dollars. Each of these steps is discussed in more detail below. Step 1: Future Cash Flows The value of a business is determined by how much cash the business can generate compared to the investment required to maintain the business. The cash flow from operations is defined as the net income of the firm plus any non-cash ex- penses such as depreciation, depletion or amortization. All other things being equal, the greater the cash flow from operations the greater the remedial action costs the firm can afford. ------- -16- Three to five years of past financial data are used to estimate the future cash flow from operations.-*- The firm's future cash flow from operations is assumed to equal the weighted average cash flow (net income plus depreciation) experienced over the past three to five years. A weighted average is used here rather than a simple average over the past three to five years. The weighted average gives greater weight to the most recent financial data; a simple average gives equal weight to each year of data. Given that the most recent data is apt to be more reflective of future operations, the weighted average will produce a more accurate estimate of future cash flows. The weights used in this analysis are shown in Exhibit 3-1. As shown in this exhibit, the most recent year of data used in the analysis is weighted twice as heavily as the data three years old and three times as heavily as data four years old. Thus, the estimated future cash flow of firms which have experienced significant downturns during the last two years will be more conservative (lower) than the estimate produced by a simple average. Similarly, the estimated future cash flow for firms experiencing rapid growth in cash flow over recent years will be higher than the estimate produced by a simple average. Use of this weighted average allows the analyst to consider all the information contained in the available data but gives greater weight to the more recent informa- tion. Step 2: Sustaining Investment Every business requires continual investment to re- place equipment as it wears out or becomes obsolete. Some of the cash generated by the business must therefore be reinvested in the business in order to maintain its earning iThree years is the minimum amount of data the system will accept. Five years of data are strongly recommended. ------- -17- Exhibit 3-1 FACTORS USED IN COMPUTING WEIGHTED AVERAGE CASH FLOWS1 Number of Years of Data Year Used In Analysis Five Four Three 5 .36 4 .25 .40 3 .18 .27 .46 2 .12 .20 .32 1 .09 .13 .22 ^These weights are derived from the following formula: weight = .3(l-.3)N-t where: N = number of years of data t = year The weights are then scaled upwards to sum to one. This formula is referred to as "exponential smoothing" and is a commonly used technique in production scheduling. See, for example, Elwood S. Buffa and William H. Taubert, Production Inventory Systems: Planning and Control, Revised Edition, Richard D. Irwin, Inc., Homewood, Illinois, 1972, pp. 40-44. ------- -18- potential. The greater the sustaining investment required, the less the firm can afford to pay in remedial action costs (all other things being equal). In times of little or no inflation the depreciation expense of the firm would be a reasonable estimate of the required sustaining investment. However, in the current decade of rapid inflation, this estimate would understate the reinvestment required. If the depreciation expense of the firm were restated to adjust for the effects of inflation, this expense could be used as an estimate of the funds required. As of 1979, the Securities and Exchange Commission (SEC) required firms to report their earnings adjusted for changes in inflation. In these statements, depreciation is reported at current cost levels. This reflects the cost of the depreciated portion of the plant and equipment at today's prices.^ This appears to be a reasonable es- timate of the funds needed to maintain current plant and equipment. To derive an estimate of sustaining investment, the price-level adjusted statements of 25 chemical and hazard- ous waste management firms were examined. For the 25 firms, the average value of the depreciation at current cost levels was 148 percent of the depreciation at histor- ical cost levels. These data are presented in Exhibit 3-2. In other words, the plant and equipment is costed out at today's prices. The depreciation is then calculated by applying the percentage depreciation on a book value basis to the plant and equipment at current cost. Depreciation at _ Plant & Equipment Book Depreciation Current Cost at Current Cost Book Value of the Plant & Equipment ^The standard deviation was 14 percent. Seventeen (17) of the 25 firms' depreciation at current cost levels fell be- tween 140 percent and 160 percent of historical cost. This indicates that there is a relatively narrow distribution about the 148 percent average, and therefore the estimate is likely to be fairly accurate for a large number of firms in these industries. ------- -19- EXHIBIT 3-2 RATIO OF DEPRECIATION AT CURRENT COST TO HISTORICAL COST DEPRECIATION (1980) Firm Ratio Browning-Ferr is 1.38 RLC, Inc.1 1.49 SCA Services 1.46 Waste Management, Inc. 1.44 Air Products 1.36 Akzona 1.54 American Cyanamid 1.87 Beker Industries 1.60 Celanese 1.382 Dexter 1.45 Dow Chemical 1.10 Ethyl Corporation 1.51 W. R. Grace 1.57 Hercules 1.60 Koppers 1.49 Monsanto 1.51 NALCO 1.29 National Distillers & Chemicals 1.66 Olin 1.42 Reichhold Chemical 1,49 Rohm & Haas 1.57 Stauffers 1.48 Sun Chemical 1.37 Union Carbide 1.54 Witco Chemical 1.44 "Tlollins Environmental Services is a subsidiary of this company. 2 1979 value. ------- -20- A value of 150 percent of depreciation was employed in the calculation of ability to pay. This estimate is extremely sensitive to the long-term inflation rate. Periodically, this value should be updated as the long-term inflation rate changes. The financial assessment system has been designed so that these changes can be made very easily.1 Also this estimate is based on an analysis of firms within the chemicals and hazardous waste management in- dustries. These industries were chosen as those most likely to be the parties involved in Superfund cases. Should other industries be heavily involved in Superfund cases, further analysis should be performed to determine the accuracy of this estimate for these other industries. Step 3: Residual Cash Flow The cash flow available for remedial action costs has been defined as the cash flow from operations after allow- ing for sufficient cash reinvestment to maintain the cur- rent operations. The cash reinvestment required (calcu- lated in Step 2) is therefore subtracted from the cash flow from operations (calculated in Step 1) to determine the residual cash available. Mathematically, the residual cash flow available in each of the past three to five years is calculated as follows: Residual Cash _ Net Income + Depreciation - Flow Available Sustaining Investment Required As stated above, the sustaining investment required is assumed to equal 150 percent of historical cost deprecia- tion. Thus, this equation becomes: ^These changes are explained in the Instruction Manual. ------- -21- Residual Cash Flow Available Net Income + Depreciation - 150% of Depreciation Net Income - 50% of Depreciation Once the residual cash flow is calculated for each year of the past five years, the weighted average is calculated by multiplying each value by the appropriate weight from Ex- hibit 3-1 and then adding the five resulting values. Exhibit 3-3 illustrates these calculations. As shown in this exhibit the average residual cash flow is $184.8 million. There is also a steady growth in the residual cash flow, due to the growth in net income. Step 4: Variability of Cash Flow Cash flow from operations may vary tremendously from year to year due to economic cycles, changes in the com- petitive marketplace, and other factors. This variability is important in determining the probability that the firm will be able to afford a given level of remedial action The variability of the residual cash flow is measured by calculating the standard deviation over the period used in the analysis. The standard deviation is a measure of how widely dispersed the past cash flows were around the average cash flow. The standard deviation is used to es- timate the portion of the time that the cash flow may be significantly less than the average value in the future. The following formula is used to calculate the standard deviation of the residual cash flows: costs. lAgain, the weighted average value is used in calculating the standard deviation. ------- Exhibit 3-3 SAMPLE CALCULATION OF WEIGHTED AVERAGE RESIDUAL CASH FLOW (Figures in millions of dollars) Average Residual Cash Flow Contribution to Weighted Year Net Income Depreciation Residual Cash Flow Weight Average^ 1980 $ 254.8 $ 86.8 $ 211.5 .36 $ 76.1 1979 237.9 80.0 197.9 .25 49.5 1978 206.3 73.6 169.5 .18 30.5 1977 175.4 67.6 141.6 .12 17.0 1976 159.9 59.0 130.4 .09 11.7 $ 184.8 i to to I 1-Net Income minus 50% of Depreciation ^From Exhibit 3-1 ^Residual Cash Flow multiplied by Weight ------- -23- SD = -Vt (RCFfc - MEAN)2 * Weighty. Where: SD = the standard deviation of the residual cash flow MEAN = the weighted average of the residual cash flows RCF-t = the residual cash flow in year t Weightt= the appropriate weight from Exhibit 3-1 for year t The calculation of the standard deviation is illustrated in Exhibit 3-4. The standard deviation of the residual cash flows in the example is $28.8 million. The standard deviation is used to estimate the disper- sion of the possible future cash flows around the mean. The dispersion of possible values around a mean is called a "probability distribution." A commonly used probability distribution—the normal distribution—is used here.1 Using a normal distribution, 50 percent of the time the value of the future cash would be expected to exceed the average cash flow. The other 50 percent of the time the cash flow would be expected to fall below the average cash flow. Thus, 50 percent of the time we would expect that the firm could afford remedial action costs equal to at least the average residual cash flow. The normal dis- tribution is used to derive the amount the firm could afford to pay with a probability higher than 50 percent. For example, if EPA wanted to know the amount a firm could ^The normal distribution is traditionally referred to as the bell-shaped curve and is often used to measure the probabil- ity that observed values will exceed the average. A detailed discussion of the normal distribution is provided in Appendix A. ------- Exhibit 3-4 CALCULATING THE STANDARD DEVIATION OF THE RESIDUAL CASH FLOW Contribution to Standard Year Residual Cash Flow Mean (RCF - Mean)2 Weight Deviation 1980 $ 211.5 $ 184.8 $ 712.9 .36 $ 256.6 1979 197.9 184.8 171.6 .25 42.9 1978 169.5 184.8 234.1 .18 42.1 1977 141.6 184.8 1,866.2 .12 223.9 1976 130.4 184.8 2,959.4 .09 266.3 Total $ 831.8 Standard Deviation (Square Root of above Total) $ 28.8 ------- -25- afford to pay with 90 percent certainty, the normal distribu- tion could be used to determine this amount as follows: Annual Cost Average _ p__fror „ qn Affordable Residual Cash Flow Where: Factor = the factors derived from the cumulative normal distribution. SD = the standard deviation of the residual cash flow. Exhibit 3-5 presents the factors used in this analysis. As shown in this exhibit, 90 percent of the time a firm is expected to have cash flows in excess of the average cash flow less 1.28 standard deviations. Step 5: Conversion to Before-Tax Dollars The residual cash flows for the firm are net of any in- come taxes paid by the firm. It is likely that most of the costs of remedial action will be tax deductible. Payment of remedial action costs will result in reduced taxes for the firm. Thus, the firm could afford to pay more in remedial ac- tion costs since the government essentially pays a portion of the remedial action costs in the form of reduced taxes. Therefore it is necessary to convert the amount of affordable remedial action costs to before-tax dollars from after-tax dollars. To do so, the annual affordable costs are divided by one minus the firm's marginal tax rate. The system uses a marginal tax rate of 40 percent. The maximum federal income tax rate for corporations is 4 6 percent. A rate of 4 0 percent is used here to account for the smaller 1-The marginal tax rate is the rate of taxation on the last dollar of earnings and should not be confused with the aver- age tax rate which is used in the interest coverage ratio discussed in Chapter 4. ------- -26- EXHIBIT 3-5 VALUES FROM THE CUMULATIVE NORMAL DISTRIBUTION Probability Number of Standard Deviations 50% 0 60 0.25 70 0.52 80 0.84 90 1.28 95 1.65 99 2.33 This table gives the probability that the observed value will exceed the average value less X standard deviations. ------- -27- or less profitable firms which may be analyzed "using this system. For larger, more profitable firms use of a 40 per- cent marginal tax rate produces a conservative (lower) esti- mate of affordable costs. If EPA wishes to adjust for this understatement, the results should be scaled upward by approx- imately 10 percent. INTERPRETATION OF THE RESULTS A sample of the results produced by the financial assess- ment system is given in Exhibit 3-6. As this exhibit shows, the system estimates that 50 percent of the time the firm can afford 308.3 million in annual remedial action costs. However, if EPA wants to be 80 percent certain that the firm will be able to afford the remedial action costs, the amount the firm could afford to pay is reduced to $267.9 million. The level of "stringency" employed in the negotiations is a matter for EPA to decide based upon factors other than financial capabil- ity. The figures provided in Exhibit 3-6 are the before-tax amounts the firm can afford to pay. Exhibit 3-6 also provides the one-time charge affordable by the firm. (Again these figures are in before-tax dollars.) This one-time charge is calculated by assuming that the firm can borrow against its future expected earnings. The amount of the one-time charge affordable is set equal to the amount of principal which could be borrowed if the annual costs af- fordable were available to pay the interest and to repay the principal over a five year period. In other words, the one- time charge affordable is the present value of a five-year stream of payments equal to the annual costs affordable at an interest rate of 20 percent. The financial ratios discussed in the next chapter can be used to determine if the firm is likely to be able to raise additional debt in order to finance a one-time charge or if an extended payment schedule is likely to be necessary. ¦'"This rate should be adjusted if interest rates change dramat- ically for a sustained period of time. The Instruction Manual explains how the program can be adjusted for alternative in- terest rates. ------- Exhibit 3-6 AFFORDABLE REMEDIAL ACTION COSTS 5/1/82 case: test case #1 PARTY: PFIZER, INCORPORATED location: new york, new york region: 2 date filed: 4/1/82 PROBABILITY OF ADEQUATE CASH FLOW 507. GO*/. 707. 807. 907. 957. 937. ANNUAL COSTS AFFORDABLE (BEFORE-TAX) 308.30 296.16 283.15 267.90 246.79 229.37 196.65 ONE-TIME CHARGE AFFORDABLE (BEFORE-TAX) 1106.78 1063.21 1016.52 961.75 885.96 823.43 705.96 THIS MEANS THAT THERE IS A 99 PERCENT CHANCE THAT PFIZER, INCORPORATED WILL BE ABLE TO AFFORD 196.65 DOLLARS ANNUALLY OR A ONE-TIME CHARGE OF 705.96 DOLLARS (ASSUMING THE FIRM WILL BE ABLE TO BORROW AGAINST FUTURE EXPECTED EARNINGS). REMEMBER THIS CALCULATION ALLOWS FOR SUFFICIENT FUNDS TO MAINTAIN THEIR CURRENT PLANT AND EQUIPMENT BUT WILL NOT ALLOW THE FIRM TO MAKE ANY SIZABLE NEW INVESTMENTS. THERE IS A 70 PERCENT PROBABILITY THAT PFIZER, INCORPORATED WILL BE ABLE TO PAY THE COST OF REMEDIAL ACTION OF 1000.00 DOLLARS ------- FINANCIAL RATIOS CHAPTER 4 The second part of the financial assessment system con- sists of three common financial ratios. The purpose of this part of the financial assessment system is twofold: 1) To indicate if the firm is likely to have difficulty financing remedial ac- tion costs if large initial expenditures are required; and 2) To alert Superfund enforcement personnel to possible defenses the firm may use to argue that it is unable to pay the re- medial action costs. The selection of the ratios is based on the financial management and bankruptcy literature. Three ratios were selected based on their proven usefulness in predicting bankruptcy and on their standard use by bankers and other financial analysts. These ratios include: 1) The ratio of cash flow to total debt, 2) The ratio of total debt to equity, and 3) The ratio of earnings before interest and taxes to interest payments (interest coverage ratio). ------- -30- Each of these ratios is described in more detail below. The rationale for the selection of the ratio, the choice of a "critical level"! and the interpretation of each ratio are discussed. Exhibit 4-1 summarizes the calcula- tion of each ratio, the critical level, and the interpre- tation of the resulting value of the ratio. The final section of this chapter discusses the combined interpre- tation of all three ratios. CASH FLOW TO TOTAL DEBT The ratio of cash flow to total debt is often referred to as "Beaver's ratio" after William H. Beaver noted its usefulness in a landmark study.2 The test involves calcu- lating the ratio of internally-generated cash flow (net income plus depreciation) to total debt (current liabilities plus long-term debt). Beaver's study demonstrated that this ratio was the single best predictor of bankruptcy when judged against individual ratios or combinations of ratios.^ This test measures the solvency of the firm and was found to be a good predictor of bankruptcy up to five years prior to failure. As discussed above, the solvency of a firm is a measure of its ability to generate sufficient cash to be able to meet its fixed obligations—interest payment, debt repayment, and so forth. Until Beaver's article appeared in 1966, most credit analysts relied on ratios which measured the liquidity of a firm; that is, how much cash could be generated quickly compared to the short-term liabilities incurred by the firm. These liquidity ratios performed very poorly rela- tive to cash flow/total debt ratio. The following table presents a comparison of the accuracy of Beaver's ratio to the current ratio—a common measure of short-term liquidity 1-The "critical level" refers to the value below or, in the case of the debt to equity ratio, above which financial difficulties are anticipated for the firm. 2William H. Beaver, "Financial Ratios as Predictors of Fail- ure," Empirical Research in Accounting: Selected Studies, 1966, University of Chicago, 1967, pp. 71-111. 3lbid., p. 101. ------- EXHIBIT 4-1 SUMMARY OF THE FINANCIAL RATIOS Ratio Calculation Critical Level Interpretation Cash Flow to Total Debt Net Income + Depreciation Current Liabilities + Long-Term Debt Below 0.10 If the value of the ratio falls below 0.10, the firm's cash flow is inadequate to sup- port future obligations and may result in insolvency. This ratio is the single best predictor of bankruptcy. Total Debt to Net Worth Current Liabilities H Long-Term Debt Stockholders' Equity Ab ove 1.5 If the value of the ratio is greater than 1.5, the firm is highly leveraged and creditors may be hesitant to extend the firm additional credit. This ratio has been shown to be moder- ately successful at predicting bankruptcy. OJ i—1 l Interest Cover- age Ratio Earnings before Interest & Taxes Interest Below 2.0 If the value of this ratio falls below 2.0, the firm may have dif- ficulty meeting its interest pay- ments in the future. The firm may also be unable to assume further debt because of limitations in its loan agreements. ------- -32- which is calculated by dividing the current assets by the current liabilities. Figure 1 PERCENTAGE OF FIRMS MISCLASSIFIEDl Years Before Failure Beaver's Ratio Current Ratio 1 13% 20% 2 21 32 3 23 36 4 24 38 5 22 45 Beaver hypothesized that the lack of predictive ability of the current ratio may be due to the firm's attempt to man- ipulate this ratio to achieve the commonly accepted standard of 2:1.2 llbid., p. 85. Misclassified implies classifying a firm which proves viable in the future as a candidate for bank- ruptcy and a firm which goes bankrupt in the future as viable. 2ibid., p. 100. ------- -33- The critical levels used by Beaver in his study ranged from 0.03 to 0.11. The critical levels which produced the best results (lowest number of misclassified firms) three to five years before failure ranged from 0.09 to 0.11. Based on this evidence and the results of a study performed by International Research and Technology using more current data,l a critical level of 0.10 was selected as an indica- tion that the firm has significant cash flow problems. If a firm falls below the critical level of 0.10, it is not necessarily the case that the firm will be unable to pay any of the remedial action costs. The size of the re- medial action costs should be taken into account in relation to the average amount of cash generated in the business as is done in the ability to pay calculation. "Failure" of this test can be interpreted as a warning that the firm may have difficulty funding any large one-time remedial action expenditures. It may be easier for the firm if the payment of the remedial action costs is spread over a number of years. TOTAL DEBT TO EQUITY Another useful aid in determining whether the firm will have the capability of borrowing additional funds to help pay the remedial action costs is the ratio of total debt to equity. This ratio is calculated by dividing the firm's total debt (current liabilities plus long-term debt) by the stockholders' equity.2 This ratio is currently used by bankers and other financial analysts to determine whether ad- ditional funds should be loaned to the firm. ^International Research & Technology (IR&T), Financial Tests as an Option for Demonstrating Financial Responsibility, Draft Report prepared for the Office of Solid Waste, Environ- mental Protection Agency, 25 November 1980, Volume II, page 4-18. This report also indicates, using more recent data on firm failures, that this ratio remains one of the best pre- dictors of bankruptcy. ^Stockholders1 equity should include common equity plus paid- in surplus and retained earnings less the value of any treasury stock. ------- -34- A measure of financial leverage—either total debt to net worth, total debt to total assets, or other similar ratios—are often included in studies or bankruptcy predic- tion. These factors have proved to be useful in predicting bankruptcy although not as useful as Beaver's ratio.-'- IR&T also found that this ratio worked well in combination with Beaver's ratio in forecasting bankruptcy. Based on IR&T's study, a critical level of 1.5 was selected.2 Once again "failure" of this test (that is, having a total debt to equity ratio which exceeds 1.5) should not be accepted as conclusive evidence that the firm cannot afford to pay any of the remedial costs. If the costs of remedial action are well within the annual cash flow available to the firm from operations, the firm is likely to be able to pay the full amount of the remedial action costs. This ratio can be used as an indication that if a large amount of borrow- ing is needed to immediately fund remedial action, the firm may be unable to obtain the funds. INTEREST COVERAGE RATIO Although this is not a ratio commonly found in the bank- ruptcy literature, this ratio is used by bankers and financial analysts to determine whether to lend money to a firm.3 in fact, this ratio often becomes an integral part of the loan covenants which prohibit the firm from borrowing additional funds (unless the new lenders agree to make their claims sub- ordinate to the original debtholders) unless an interest coverage ratio of 2.0 is maintained. Because of these insti- tutional arrangements, the interest coverage ratio is an important factor to consider when assessing the firm's borrow- ing capability. "'"Kung H. Chen and Thomas A. Shimerda, "An Empirical Analysis of Useful Financial Ratios," Financial Management, Spring 1981, pp. 56-59. 2 Op. Cit., Volume II, p. 4-18. The value of 1.5 is extremely conservative; that is, firms without financial problems are more likely to be misclassified than firms with financial difficulties. If the firm fails only this ratio, it may still have the ability to incur substantial additional debt. ^Accounting: The Basis for Business Decisions, Walter B. Meige, Charles F. Johnson, and Robert F. Meige, 1977. ------- -35- Th e interest coverage ratio is the ratio of the earn- ings before interest and taxes to the interest payments of the firm. This ratio indicates whether or not the firm will be able to meet its interest payments. We have employed 2.0 as the critical level in this analysis. Firms with interest coverage ratios below 2.0 may find it difficult to borrow additional funds. Once again a firm which "fails" the interest coverage ratio (has a ratio below 2.0) need not be immediately ex- empted from having to pay any of the remedial action costs. "Failure" can be interpreted in the same manner as before. It is an indication that the firm may have difficulty financ- ing the remedial action if the remedial action costs are greater than the available cash flow in any given year. INTERPRETATION OF ALL THREE RATIOS It is possible that the firm may pass one or two of the financial ratios while failing the remaining ratios. The system is designed to print a warning if the firm fails two or more of the three financial ratios. This warning is meant to (1) indicate that there may be a need to work out an extended payment schedule so that the firm can spread the remedial action costs over several years, and (2) alert EPA to the fact that the firm may use these ratios or a similar analysis in contending that they cannot pay any of the remedi- al action costs. It is possible that the financial ratios may indicate that the firm has serious financial problems and yet the ability to pay calculation indicates that the firm can afford a large portion of the remedial action costs, This is likely to be ^In the absence of available data, the program may be unable to calculate one or more of the financial ratios. The pro- gram will indicate which ratios cannot be calculated. If one ratio cannot be calculated, the firm must fail both of the remaining ratios in order for the warning to be printed. If two or three of the ratios cannot be calculated, no warn- ing will be printed but the value of any ratio which can be calculated will be provided. ------- -36- due to the large amount of debt relative to equity, or to the poor cash flow generated in the most recent year. Similarly, there is a possibility that the firm will successfully pass all the financial ratios and still be un- able to pay any of the remedial action costs. This may indicate that the firm's liabilities are small in relation to the cash flow generated by operations; but that the cash flow generated from operations is still inadequate to allow the firm to maintain its operations. The firm remains in business by not reinvesting sufficient capital in its bus- iness. Not investing maintaining capital is a short-term strategy which can eventually lead to failure or to the necessity to close down portions of the firm's operations. ------- NORMAL DISTRIBUTION APPENDIX A INTRODUCTION The dispersion of possible outcomes around the mean or average value can be described as a probability distribu- tion. The normal distribution is a commonly used probabili- ty distribution. The normal distribution is often used to describe the dispersion of outcomes about the average value since outcomes of scientific experiments (for example, the heights and weights of individuals in a homogeneous popula- tion) and natural events often have distributions which are approximately normal. The characteristics of the normal dis- tribution are described below.1 CHARACTERISTICS OF THE NORMAL DISTRIBUTION Exhibit A-l illustrates the shape of the normal distribu- tion. Point Y on the curve denotes the likelihood (probabil- ity) that value X will occur. The area under the curve to the left of the dotted line indicates the probability that the outcome will take on a value equal to or less than X. ^For a more complete discussion of the normal distribution, see any introductory statistics textbook. ------- -38- Exhibit A-l NORMAL PROBABILITY DISTRIBUTION * > Probability Average x Possible Value Outcomes The shaded area equals the probability that the outcome will have a value less than or equal to x. ------- -39- The familiar "bell-shaped" curve shown in the exhibit has a few important characteristics. First, the outcome is equally likely to fall below or above the average of the distribution. Second, 95 percent of the time the outcome will fall within two standard deviations^ of the average; and 68 percent of the time the outcome will fall within one standard deviation of the average. The use of the normal distribution in calculating ability to pay is best illustrated by using the "cumulative probability distribution curve" shown in Exhibit A-2. Each point along this curve represents the probability that the outcome will be equal to or less than a given value. For example, 50 percent of the time the outcome will be less than or equal to the average value. From this cumulative distribution curve, the factors shown in Exhibit 3-5 are derived. ^Ths standard deviation is defined in Chapter 4. ------- -40- Exhibit A-2 CUMULATIVE PROBABILITY DISTRIBUTION Average - 2 Standard Deviations Value Average + 2 Standard Deviations Possible Outcomes y represents the probability that the outcome will be less than or equal to the value x ------- |