Question
You have been asked by the managing director of Winner plc to 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 for the company's last two years: & 2021 & 2022 Gearing ratio & 50 % & 60 % }(l) Interest cover ratio & 5.6 times & 2.1 times Required: (a) Evaluate the financial gearing of the company based on the two ratios provided. Your evaluation must cover the reasons behind the observed changes in ratios 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) Discuss two advantages and two disadvantages of debt as a source of finance from the perspective of the financial manager. (8 marks) (Total: 20 marks)
Answer
4.3
(176 Votes)
Kyle
Elite · Tutor for 8 years
Answer
(a) The company's financial gearing has increased (as measured by an increased Gearing Ratio), which is a concerning trend because the company's Interest Cover is substantially lower. This exposes the company to a higher level of financial risk. (b) Based on the available information, I would not recommend the manager to obtain more loans since this could increase the financial risk to a dangerous level. (c) Two advantages of debt as a source of finance, as seen from a financial manager’s perspective, include: 1) Debt can fast-track the firm growth by allowing investments in opportunities than otherwise not possible without it. 2) If the returns higher than the cost of debt (interest rate), debt acts a leverage that can enhance return for equity shareholders. Two disadvantages include: 1) By increasing debt beyond the feasible limit, the company becomes more susceptible to falling into a financial catastrophe, particularly during periods of fluctuating economical stability or falling sales, as profits might not enough to cover interest cost, causing financial risk. 2) Cost of debt (interest expense) could reduce profit margins and decreased return to equity of the shareholders, affecting business profitability negatively.
Explanation
## Step 1: Understanding the provided ratiosThe gearing ratio indicates the relative proportion of debt in the corporate financing structure. It's an indicator of the financial leverage of the company. It grew from 50% to 60%.Interest cover ratio, on the other hand, gauges a company's ability to pay off its interest expenses with its earnings before interest and tax in a given period. It fell significantly from 5.6 to 2.1 times. A rising gearing ratio and falling interest cover reflects that the company is gradually elevating its risk profile by taking on more debt.## Step 2: Analysis of the financial situation based on ratiosThe gear ratio movement indicates that the company has been progressively increasing its borrowings in the capital structure. However, since interest cover has reduced significantly from 5.6 to 2.1 times, this suggests the company's ability to service its debts (through profits) is drastically depreciated. ## Step 3: Evaluate whether the company should borrow money or not Considering the upward trend in the gearling ratio and a substantial downward movement in the interest cover, the company needs to bolster its income or cut its borrowing needs, as its current debt level is on the riskier side. Due to the grown debt risk, borrowing more might aggravate the risk profile to unacceptable levels. ## Step 4: Discuss the pros and cons of debt as the source of finance from the financial manager's perspectiveAdvantages: Debt can facilitate a company's growth at a faster pace and act as a leverage to increase returns to equity holders.Disadvantages: Debt has an interest burden, and hence profitability should be higher to accommodate for this expense. Also, the higher the debt, the greater the business risk the company takes on.