Thursday, December 12, 2019
Financial Analysis Various Business -Myassignmenthelp.Com
Question: Discuss about the Financial Analysis Various Business. Answer: Introduction The external sources of finance can be procured in many ways and constitute an important source to the company. It is not always possible for the company to conduct the operation with the help of internal finance and hence, arises the need for an external source of finance. Further, an external source of finance is of utmost importance when it comes to expansion as funds can be procured. Lack of external source of finance can be a setback as that might limit the scope for expansion (Fields, 2011). However, the same needs to be evaluated in various parameters. A public company can raise finance through equity and debt. However, the impact by both these need to be ascertained because selection cannot be done randomly. A proper balance between equity and debt creates a better prospect (Arnold, 2010). Both the sources have its own advantages and disadvantages. The report strives to evaluate five different sources of finance available to a limited company and the factors that need to be g auged before selecting a particular source of finance. Moreover, the report stresses on WACC that is another important factor and is defined as the rate where the company needs to pay on average to the security holders so that assets can be financed (Melville, 2013). It is influenced by the long term sources that will be discussed in an elaborate manner. Purpose The purpose of the study is to evaluate five different sources of external finance that is available to a public limited company. Further, the study strives to provide a strong balance between the advantages and disadvantages of each source. Another main purpose that has been served by the study is the consideration that plays a pre dominant role in selecting a source of finance. Scope The scope of the study is to shed light on the five different sources of finance that is available to the public listed company. To have a better scope and study, the selection of GKN Plc is done. Moreover, the scope of the study is to shed light on the benefits and disadvantages that every source of finance contain. It is important to ascertain every source because the application and benefit might vary as per the scenario and the companys mode of operation. Further, the report aims to draw attention to the concept of WACC and the fact that is influenced by the long term sources. Methodology For the purpose of the study the data selection is done through secondary data. For the purpose of the study, the collection of data has been from books, report, internet pages, websites, etc. Different sources have been accessed so as to gather an exhaustive view of the entire study. Further, it helps in the better projection of the matter. The data and other statistics have been used from the annual report of GKN PLC. Limitation The study suffers from few limitations. The first and foremost problem is with the selection of a public company. In the study, the context is a public limited company. However, different public limited have different needs and accordingly the selection of sources of finance needs to be done. The study is based on a wider perspective and therefore catering to the individual company will be the different and different result will be observed. Secondly, the study is based on five external sources of finance whereas there are many options available. Hence, there is a limitation or constraint when it comes to the sources of finance that might lead to a difference in the result. Issue of Share Equities are one of the commonly used sources of funding for many companies. In equities, there is no fixed obligation on the company to pay a dividend. Equities provide the company a chance to borrow funds openly as and when required (Brealey et. al, 2011). They are used to manage the working capital requirements of the company and help to increase the retained earnings. It is also allowed to the companies to issue shares to the existing shareholders, this is known as a right issue. Advantages Unlike the fresh issue, the issue of right shares has a very low floatation cost. The cost incurred by the company to raise funds is known as floatation cost (Merchant, 2012). Hence, it can be raised without hassle. This is of paramount importance and enables the company to procure funds easily. The components of such floatation cost are underwriting fees, brokerage, and several other issue expenses. Moreover, it enables to have a strong grasp over the retained earnings that ultimately helps the company in the long run. Disadvantage Equities are a high-risk investment so the expectation of the shareholders to get higher returns also increases. The company also has to appoint underwriters in order to handle the situation of under subscription for which certain amount of commission has to be paid to them. There is a dilution of control in case of fresh issue (Choi Meek, 2011). Equities do not have to get any benefit of leverage as well as it also does not get tax benefits as the dividend paid to the shareholders are not tax deductible. Issue of Preference Share The issue of preference is another option that can be used for raising finance. It constitutes an important source because it has special or priority rights attached to it. The dividend is fixed in nature and payment is done before any payment is done to the equity shareholder. the best thing that is contained in this form of raising finance is that the voting rights are not diluted. The preference shareholders are not entitled to have voting rights (Gibson, 2012). Advantage The preference shares which also form a part of the equities also has certain merits such as there is no obligation on the company to pay a dividend every year also there is no control dilution. The issue of preference shares helps to enhance the borrowing capacity of a company and these are considered safe as there is no charge on the assets of the company. Apart from these advantages it also has some disadvantages (Choi Meek, 2011). Disadvantage Preference shares are usually a costly source of raising finance. Although there is no obligation on the company to pay a dividend if a company fails to pay a dividend then there is a loss of reputation in the market. Issue of debentures Debentures are considered as the cheapest source of finance. They are repaid after a fixed interval of time and do not give the holders the right to vote so there is no dilution of control. The debentures can be either secured or unsecured. Debentures are preferred in the situation of inflation (Brigham E, 2011). Advantages The advantage that debentures carry is that there is no dilution of equity shareholder interest as they contain no right in participation or voting in the companys management. Further, the interest on debenture is tax deductible and hence, it helps in having of taxes. As compared to other forms of finance like preference and equity share the cost is low. Funds can be procured easily and thereby a greater pool of funds can be attained easily. Disadvantages There are also many demerits some of which are- the company also has to pay interest when there are losses incurred, it results in an increase of financial risk of the company and also there is a huge cash outflow when there is the redemption of debentures. Over dependence on debentures can lead to a huge setback as there will be more reliance on the borrowed funds. Moreover, the huge interest can ruin the cash flow of the company and might lead to disruptions. During the time of low cash flow, the company has insufficient funds and at that point of time, it becomes difficult to pay the interest. Banks loans and advances A bank loan is a part of the debt. A bank loan is easy to procure with very less legal formalities. These loans can be taken for the desired period as per the requirement of the company. The company gets a tax benefit as the interest is regarded as a tax deductible expense. However, taking a huge bank loan can also affect the cash flows of the company (Berk et. al, 2015). There is sometimes also a situation when the bank provides a lesser amount of funds than what is applied for. There may also be some prepayment charges or penalties charged which is one of the major disadvantages. Advantages The legal complexity involved in the procurement of bank loans is less. Such loans can be procured as per the needs of the company. The public company is able to have a tax benefit as the interest is tax deductible. Disadvantage When it comes to interest rates of bank loans, it can run high and therefore a major chunk of the companys profit goes towards payment of interest. When it comes to the process of expansion, there is always a requirement for funds and the interest rate always prove to be of a major problem (Williams, 2012). If the business does not have sufficient cash flow, it can face immense problem while its repayment. Leasing and Hire purchase Hire purchase and lease are another options of external sources of finance. It helps the firm to possess or control an asset as per the terms that are agreed. Rent or installment is paid that covers the depreciation and interest of the asset needed to cover the cost of capital (Guerard, 2013). However, leases differ in the sense that lessee does not contain ownership rights to the asset. Both the arrangement helps the business in performing the activity without owning the asset. In short, a huge outlay is deferred and the company is able to carry on the activities with ease and flexibility. Advantage HP or leasing benefits the public company that is they are allowed to have a control over the assets. There are fewer burdens on the working capital Secondly, repayment structuring is flexible that helps to reduce the outlay of the month. Moreover, it helps in tax efficiency because lease payment is booked as an expense. The arrangement of a lease is free from huge procedures. The documentation is easy and simple as compared to the loans. Disadvantage The total capital payment done for HP or leasing is higher as compared to the purchase of the entire asset. Moreover, there appears higher level of complexity in terms of arrangement like a change in equipment location, etc. further, if the business makes a shift in the strategy and the leased asset is not useful then it can be subjected to termination charges. Critical evaluation It is evident from the above study that different sources of finance have its own merits and demerits. It depends specifically upon the requirement of the company to use a particular source of finance. Companies that need to expand and increase its reach and availability will opt for a combination of equity and debt. The debt will be more if the company is adventurous in nature and has strong outflows that can help in payment of the interest. However, equity will be more when the company is orthodox and is more inclined in making a steady progress. Other forms of finance like bank loans, the lease will depend upon the necessity. When the company does not want to drain its cash or funds then the option of the lease or hire purchase can be availed (Libby et. al, 2011). Bank loans are typically done when the company wants to own something and it involves ownership. Capital Structure of three identical firms The ROE of the company can be bettered as compared to the current scenario. It needs to enhance the level of net income to post better ROE. GKN Plc should ensure an effective cash conversion cycle that will enable the company to convert the debtors, inventories, and receivables into cash leading to better projection. The company can even utilize the debt capacity to a further extent so that utmost advantage can be fetched (Guerard, 2013). If the management is able to chalk out a strategy and curb the unwanted expenses then it is likely to figure more profits. The operating expenses have surged considerably and hence, require the attention of management for posting more profits. Surface Transforms is an identical firm and going by the analysis it can be commented that the company needs to stress upon the net income factor because it is not operating at full capacity as witnessed by the annual report. The company failed to utilize the debt in any scenario and comprises of equity. This means the company can enhance by introducing debt. Torotrak Plc has utilized both equities, as well as debt and going by the operations and ROE it can be commented that the company has a better ROE that signifies a better return on the investment. However, for a better structure, the company can enhance the level of debt that will provide stability to the funding source. Going by the capital structure of the three identical firms it can be commented that GKN Plc is better placed in terms of capital structure. It has the capacity to enhance the level of ROE from the current level and has a better structure as compared to the other two firms. Weighted Average cost of Capital WACC can be defined as the rate where a company is needed to expand in total to every shareholder so that assets can be financed, it projects the return on a minimal basis that a company must receive on a particular assets base so that the needs of the owner, capital providers, creditors, can be evaluated. It is defined as the cost of capital of a firm that is defined by the external circumstances and not the one prevailing in the market (Brigham Daves, 2012). Both debt and equity are primary sources of finance available in capital markets that can affect the weighted average cost of capital (WACC) of a company. If it is assumed that the cost of long-term debt employed by a listed company is not equivalent to its cost of equity, any variation in the capital structure can affect the WACC. Nevertheless, in general, the cost of long-term debt in companies is lower than their cost of equity (Deegan, 2011). Therefore, if long-term sources of finance are increased, the WACC of the company will significantly decline. Similarly, in the case of equity financing, the cost of equity being greater than debt, will result in an increase in WACC when equity financing is increased (Ferris et. al, 2010). Nevertheless, since debt financing can be easily attained, this can maximize the proportion of debt to equity. As a result, the cost of debt being less expensive than equity financing, the WACC of the company will effectively fall. Moreover, economists hav e stated that it is a common mistake to assume that WACC of a company can be reduced by enhancing a number of long-term sources of finance (Henderson et.al, 2015). This is because if such strategy works, companies can easily gain an opportunity to obtain as much debt as possible until it does not pose a risk to them. Debt is always exposed to risk and hence, there must be proper evaluation regarding the appetite of the business. If the business is strong and cash flow is not a consideration then debt financing can be easily availed and procured. However, in the case of any shortfalls, the company should not opt for debt financing as it might lead to issues in the long run. Furthermore, this argument disregards the fact that even if the debt is risk-free in nature and there are minimal chances for the company to default in future, adding more leverage, in turn, enhances the risk of equity for the company (Vaitilingam, 2010). Taking into consideration such increase in risk, the equity holders will become forced to demand enhanced risk premium that will, in turn, offset the advantages of a greater dependence on cheaper long-term sources of finance, thereby making nil changes to the overall WACC of the company (Deegan, 2011). Therefore, as the company borrows at a lower cost of capital for debt, its cost of equity will significantly enhance. This will result in a nil change in the companys WACC. This is because as the proportion of debt enhances, it becomes riskier in nature as there is a possibility that the company may default in the upcoming future, thereby resulting in an increment of debt cost of capital (Petersen Plenborg, 2012). Moreover, with 100% debt in the capital structure of the company, the debt would become riskier just like its assets. However, even though the equity and debt cost of capital both increases when the leverage is high due to the immense weight being placed on lower-cost debt, the weighted average cost of capital remains constant (Bod ie et. al, 2014). This proves that the companies must expend a combination of different types of costs on all sources of finance so that a minimal variation in any long-term source of finance can affect the WACC as well. In simple words, if a companys debt is enhanced from 10% to 50%, its equity level will consecutively fall in the exact same proportion when the company computes its WACC. Hence, if a company intends to decrease its weighted average cost of capital, it can maximize its utilization of more cheaper long-term sources of finance like debts. Over the longer time frame, this will help the company in running to full capacity and create more opportunities (Merchant, 2012). If the capital structure is complicated in nature, more is the problem in computing the WACC. As the asset of the company is financed by equity or debt, it influences the WACC of the company. The matter that the cost of debt does not equals the cost of equity projects that WACC is impacted by a change in the structure of the capital (Bodie et. al, 2014). Therefore, being a combination of various costs needs to be paid to every source of finance. If there is a marginal increment in the long-term source of finance than the WACC will be influenced. If the debt level of the company enhances to 80% from an existing range of 40% then it reflects that the equity will drop in the same proportion while computing the WACC. If the company wants to lower the WACC then it can enhance the sources of finance that is cheaper in nature like the debt of long term (Spiceland et. al, 2011). When the company gets financing easily through debt it lifts the debt scenario and as the debt cost is cheaper as compared to equity the WACC will decline. Conclusion Considering the discussion above, various factors must be considered for the selection of the type of finance. Firstly, the structure of fees and other interest types must be known. However, investment will differ as per the cost and another financing method. Secondly, terms of repayment must be known because huge loans can increase interest on the contrary smaller loans need more periodic payments (Brigham, 2011). Last but not the least, the selection of finance must suit the companys policy and functioning that will aid in providing a high-end result. Moreover, the computation of WACC can be done by ascertaining the relative weights of an element such as debt, liabilities, options, etc that pertain to the capital structure. Therefore, the elements have a direct bearing on the capital structure. References Arnold, G 2010, The Financial Times Guide to Investing, Prentice Hall. Berk, J, DeMarzo, P Stangeland, D 2015, Corporate Finance, Canadian Toronto: Pearson Canada. Brealey, R., Myers, S. Allen, F 2011, Principles of corporate finance, New York: McGraw-Hill/Irwin. Brigham, E. Daves, P 2012, Intermediate Financial Management , USA: Cengage Brigham, E.F. Ehrhardt, M.C 2011, Financial Management: Theory and Practice, USA: Cengage Learning. Bodie, Z., Kane, A. Marcus, A. J 2014, Investments, McGraw Hill Choi, R.D. Meek, G.K 2011, International accounting, Pearson Press . Deegan, C. 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