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 amount of marks.
Unfortunately, many students struggle with questions of this nature and do not seem to know how to produce a good answer. This article will suggest an approach that students could 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 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 turnover, 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 income statement. 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. If the examiner has not provided such data, it is simply because he is constrained by the need to examine many topics in just three hours.
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
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, $15m of which is held in cash on deposit. This could presumably be used to help fund the expansion and, if this is the case, the need for additional finance would be reduced to $75m. However, the company may have a reason for holding cash – for example, to meet budgeted cash payments in the near future.
Forecast financial performance
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 income statements for the years ending 31 May 20X2 and 20X5 are shown below. Two income statements have been prepared for 20X5, one assuming the expansion is funded by debt and the other assuming the expansion is funded by equity:
|20X5 – debt|
Profit before tax
Tax – 28%
Profit after tax
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
Note: While it would be good to forecast the income statement for each year, time pressure may mean this is not possible.
This analysis shows that the growth in revenue caused by the expansion is exceeded by the growth in operating profit due to a steady 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. Whether debt finance or equity finance is used, both the returns to all investors (operating profit) and the return to the equity investors (profit after tax) both show considerable growth.
Current and forecast financial position
The gearing (D/E) is currently 70/146 = 47.9% on a book value basis. If debt finance is raised this would rise to (70+75)/146 = 99.3%, while if equity finance was used it would fall to 70/(146+75) = 31.7%. Even if debt finance was raised the gearing level would rapidly fall again as the company makes and retains profits.
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. However, by 20X5 it would have recovered to 37.1/11.0 = 3.4 times. If equity finance were to be used the interest cover would consistently improve.
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 would initially rise slightly above the sector average but would soon return to the sector average level or below.
From the analysis and discussion above, it would seem that Refgun Co should seek to finance the expansion by raising long-term debt secured on the existing non-current assets of the company and the new non-current assets acquired during the expansion. At the same time as raising the new debt, the refinancing of the existing debt should also be considered. If shareholders and other key stakeholders are concerned about the financial risk exceeding the industry average, then Refgun Co could raise some short-term debt with the aim of repaying it as soon as more cash is earned. The directors should take action to manage the interest rate risk that Refgun Co will suffer.
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