Question
You have been asked by the managing advise the company on the feasibility of raising a 5 -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 }(l) Gearing ratio & 75 % & 60 % Interest cover ratio & 4.1 & 6.5 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
Answer
4.5
(210 Votes)
Thomas
Professional · Tutor for 6 years
Answer
# Explanation:## Step1: Evaluate the Financial GearingThe financial gearing of a company is calculated by comparing the company's debt (usually long-term debt) to its shareholders' equity. It shows the extent to which a company's operations are financed through debt. The gearing ratio is also used to assess financial risk – a higher percentage reveals a higher financial risk, as it shows that a larger proportion of funding comes from external borrowing. In this case, the company’s financial gearing has decreed from 75% in 2022 to 60% in 2023. The improvement in the financial gearing ratio could mean the company is lessening its viability and thus lowering its financial risk. This could be due to payments of existing loans, profitability enhancing internal financing, or fundraising through equity which reduces the proportion of debt in overall financing.## Step2: Evaluate the Interest Cover Ratio Interest cover ratio indicates a company's ability to make interest payments on its debt. It's calculated as earnings before interest and tax (EBIT) over interest expenses – a larger ratio shows that a firm is more capable of meeting its interest liabilities from earnings. The interest cover ratio for this company has increased from 4.1 times in 2022 to 6.5 times in 2023. This improvement indicates that the company is in a better position to service its existing debt obligations without putting strain on operational performance.## Step3: ConclusionConsidering these ratios, the debt level seems to have reduced while the capacity to repay debt with current earnings improved through the years. They indicate reduced financial risk and improved financial stability in the firm, suggesting that the company might be able to handle further loan commitments.# Answer: Based on the evaluation, the managing team could consider the option to finance the factory machinery through a 5-year loan.# Explanation:## On factors influencing a decision to issue debt or equity:1. Cost of CapitalDebt is usually cheaper to issue due to tax-deductible interest expenses, while equity is more costly as dividends payable are not tax-deductible.2. Risk Level:Through issuing equity the business avoids incurring more financial obligations such rewarding repeated dividends, triggering a downfall, and causing bankruptcy, unlike taking on more debt obligations would require ongoing payouts, which if neglected, would potentially push the entity into insolvency.3. Influence on Control:Equity financing would dilute current owners' stake and could potentially dilute the control they hold over the company, while debt allows the owners to maintain full control as long as debt obligations are fulfilled.4. Market Conditions:Prevailing market conditions determine whether it is best to raise financing through debt or issuing equity. If the cost of borrowing is low and the market is receptive to either debt or equity, debt could be a more attractive option.# Answer:Based on the factors listed and interpreted above, it helps a firm to decide whether they should opt to finance through debt or equity issuance. A good slap on positive signs would work more, skirts tight market conditions but also keeps feasibility brief. It's vital to weigh the pros and cons of each option in light of the gearing ratio and the interest cover ratio before deciding.