The requirement to analyse suitable financing alternatives for a company has been common in Financial Management over the years. I am sure it will be examined again in the future. This is a key area in the Financial Management syllabus and the requirement can be worth a significant number of marks.
Unfortunately, many students struggle with questions of this nature and are unsure how to produce a good answer. This article will suggest an approach for students to use and will then finish with a worked example to demonstrate the technique discussed.
When considering the source of finance to be used by a company, the recent financial performance, the current financial position and the expected future financial position and performance of the company needs to be taken into account. Within an exam question, the ability to do this will be restricted by the information available. In some questions, details of recent performance and the current situation may be provided, while in other questions the current situation and forecasts may be provided.
Whether you are evaluating recent or forecast financial performance, key areas to consider include the growth in revenue, the growth in operating profit, the growth in profit after or before tax and the movement in profit margins. Return on capital employed and return on equity could be calculated. A key point for students to remember is that they only have limited time and it is better to calculate a few key ratios and then move on and complete the question than it is to calculate all possible ratios and fail to satisfy the requirement.
The key consideration when evaluating the current financial position is to establish the financial risk of the company. Hence, the key ratios to calculate are the financial gearing, which shows the financial risk using data from the statement of financial position and interest cover, which shows the financial risk using data from the statement of profit or loss. Equally, the split between short and long-term financing, and the reliance of the company on overdraft finance, should also be considered.
When evaluating financial performance and financial position, due consideration should be given to any comparative sector data provided. Indeed, if no such data is provided, I would recommend that you state in your answer that you would want to consider such comparative data. This is what you would do in real life and stating it shows that you are aware of this.
When recommending a financing method, consideration should be given to a number of factors. These factors are key to justifying your choice of method and the examiner has in the past asked students to discuss these factors in an exam question. The factors include:
While this list is not meant to be exhaustive, it hopefully provides much for students to think about. Students should not necessarily expect to use all the factors in an answer.
Students must ensure that they can suggest suitable financing sources. For each source, students should know how and when it could be raised, the nature of the finance and its potential advantages and disadvantages. Combined with a consideration of the factors given above, this knowledge will allow students to recommend and justify a source of finance for any particular scenario. A discussion of each finance source is outside the scope of this article, but students can read up on this area in any good study manual.
The following forecast financial position statement as at 31 May 20X2 refers to Refgun Co, a stock exchange-listed company, which is seeking to spend $90m in cash on a permanent expansion of its existing trade.
Equity and liabilities
Total equity and liabilities
Total dividends for the year ended 31 May 20X2 are $6m, which is $0.10 per share. The forecast results for Refgun Co, assuming the expansion occurs from 1 June 20X2, are as follows:
Recommend a suitable method of raising the finance required by Refgun Co, supporting your evaluation with both analysis and critical discussion.
Prior to reading the suggested solution students should carry out their own evaluation of the forecast financial performance and the current and forecast financial position. A consideration of the factors discussed earlier should lead students to a justified recommendation.
Refgun Co is seeking to spend $90m on a permanent expansion of its existing trade. It should be noted that the company has significant retained earnings, although it’s important to remember that retained earnings do not mean cash available for investment – ie in this example that $86m of retained earnings does not represent available cash to finance the expansion, this amount is the previously highlighted $15m.
The forecast financial performance of Refgun Co will be a key consideration to potential finance providers. Analysis of the forecast performance of Refgun Co gives the following information:
Year ending 31 May
Operating profit margin
The forecast statements of profit or loss for the years ending 31 May 20X2 and 20X3 are shown below. Two statements of profit or loss have been prepared for 20X3, one assuming the expansion is funded by debt and the other assuming the expansion is funded by equity:
The interest charge for 20X2 is assumed to be (70 x 8%) = $ 5.6m. If debt finance is used the interest charge from 20X3 onwards is assumed to be (70 x 8%) + (75 x 7.2%) = $11.0m
This analysis shows that the growth in revenue caused by the expansion is exceeded by the growth in operating profit due to the rise in the operating margin of the company. This may be a result of the company benefiting from economies of scale as a result of the expansion. If debt finance is used, although operating profit is higher, profit after tax is lower than in the current year. However, if equity finance is used, both the returns to all investors (operating profit) and the return to the equity investors (profit after tax) show growth.
The gearing (D/E) is currently 70/146 = 47.9% on a carrying value basis. If debt finance is raised this would immediately rise to (70+75)/146 = 99.3%, while if equity finance was used it would fall to 70/(146+75) = 31.7%. It's important to remember that the carrying value of equity will also adjust each year by the level of retained earnings for the year. Therefore, even if debt finance was raised the gearing level would fall again as the company makes and retains profits. After 1 year, the gearing would be (70+75)/(146+6) = 95.4% under debt financing or 70/(146+75+7.69) = 30.7% under equity financing, compared to a sector average of 75%.
The interest cover is currently 24.4/5.6 = 4.4 times. If debt finance is used then this would fall to 28.5/11.0 = 2.6 times in 20X3, just below the industry average of 3.5 times. If equity finance were to be used the interest cover would be 28.5/5.6 = 5.1 times in 20X3.
Refgun Co currently has less financial risk than the sector average and the financial risk would decline even further if equity finance was used. If debt finance is used then the financial risk measured by gearing and interest cover would initially be above and below the respective sector averages.
From the analysis and discussion above, it would seem that Refgun Co should seek to finance the expansion by raising equity finance, as using debt finance would mean shareholders and other key stakeholders could be concerned about the financial risk exceeding the industry average.
I hope that this article has provided students with an approach that they can use when answering a question of this nature. All too often students have a feel for the type of finance that may be suitable for a company, but cannot support or justify what they are proposing and, hence, cannot earn the marks that are available.
William Parrott is a lecturer at Kaplan Financial