Question
You have been asked by the managing director of mathrm(XYZ) plc to advise the company on the feasibility of raising a 7 -year loan to finance the purchase of new factory machinery. To help you with your analysis, you have been given the following ratios from the company's financial statements for the last two years: & 2022 & 2023 Gearing ratio & 55 % & 25 % Interest cover ratio & 4 times & 15 times Required: (a) Evaluate the financial gearing of the company based on the two ratios provided. Your evaluation must cover what each ratio represents, an analysis of the observed changes in each ratio, the reasons behind such changes over the two years and the potential implications of such changes. (10 marks) (b) Based on your evaluation, recommend to the manager (with reason) whether they should consider raising the needed funds through borrowing. ( 2 marks) (c) Identify and briefly discuss four factors that influence a firm's decision to issue debt or equity for financing. ( 8 marks)
Answer
4.6
(175 Votes)
Fletcher
Advanced · Tutor for 1 years
Answer
(a) Gearing ratio and Interest cover ratio are two financial ratios that give insights into a company's financial health, particularly its ability to accommodate borrowings.Gearing Ratio: It reflects a company's capital structure and measures the degree to which its activities are supported by owner versus debt funding. The firm's gearing ratio decreased from 55% in 2022 to 25% in 2023, which suggests a reduction in the proportion of debt in the company's capital structure. This decrease might be due to the repayment of any existing debt, or an increase in equity funded by company’s earnings or fresh infusion of capital through the issue of new stock. Lower gearing indicates a decreased dependency on debt, consequently lowering the financial risk associated with the repayment and interest obligations. Interest Cover Ratio: It's an indicator of how easily a company can manage its interest payments. A rise from 4 times in 2022 to 15 times in 2023 indicates that the company can meet its interest payments using operative profits more comfortably now than in the past. This increase in interest cover could be due to rise in operating profits or a decline of interest expenses, also pointing towards better financial stability. (b) Given that the company's gearing ratio indicates decreased adoption of debt and its interest cover ratio affirms its efficiency in managing interest payments from profits, my advice would be to consider raising funds needed through borrowing. The company seems to be in a secure financial position to handle additional debt, considering it's able to generate sufficient profits to meet debt obligations and it has a reduced dependency on debt.(c) Here are four factors influencing a company's choice to finance through debt or equity:1. Cost of Capital: Debt is generally cheaper than equity as interest expense is tax-deductible.2. Ownership Dilution: Equity financing would mean sharing the ownership and hence the profit. 3. Financial Risk: High debt burden comes with obligation of repayment and high risk, irrespective of business performance.4. Market Conditions: In favourable market condition with a positive business outlook, equity financing may be preferred. Affirmitive answer in this case would be:I recommend the managing director for considering the loan ("raising funds through borrowing") again to finance the purchase of new factory machinery since the firm's Gearing ratio and Interest Cover ratio analysis strongly suggest that the company is indeed capable of handling more debt.