Financial Analysis & Financial Tools - FAQ
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"The assessment of funds needed by the company should be made in such a way that the amount of funds available should be neither too long nor too less" Discuss
Assessment of finance required should cover the cost of investments needed by the company and should comprise of an optimum mix of equity and debt to leverage the maximum value for the shareholders.
Two of the major decisions involved in financial management are the financing decision and the investment decision. Financial management is thus concerned with decision-making in regard to the size and composition of assets and the level and structure of finance. The investment decision is broadly concerned with the asset-mix or the composition of the assets of the firm. On the other hand the concern of the financing decision in addition to the acquisition of the funds, is directly concerned with the financing-mix, or capital structure or leverage. What finance and how much of it? The term capital structure refers to the proportion of debt (fixed interest sources of finance) and equity capital (variable-dividend securities/sources of funds). The financing decision of a firm relates to the choice of the proportion of these sources to finance the investment requirement. There are two aspects of the financing decision. First, the theory of capital structured which shows the theoretical relationship between the employment of debt and the return to the shareholders. The use of debt implies a higher return to the shareholders as also the financial risks. A proper balance between debt and equity to ensure a trade-off between risk and return to the shareholder is necessary and realise the objective of financial management. The objective of the firm should be to maximise the value of the firm to its equity shareholders
Savings are allocated primarily on the basis of the expected return and risk and the market value of the firm's equity stock reflects the risk-return trade off of investors in the market place. Hence when a firm maximizes the market value of its equity stock, it ensures that its decisions are consistent with the risk-return preference of the investors. This suggests that it allocate resources optimally. If the firm does not pursue the goal of shareholders wealth maximisation, it implies that its actions result in sub-optimal allocation of resources or over optimal allocation of resources. This in turn leads to inadequate capital formation or over-abundant creation of capital. In adequate capital formation exposes the interests of the firm to undue risk, while over-capitalization leads to low profitability.
Risk and return are the two basic dimension of all financial analysis. Suppose a firm is evaluating an investment proposal, what aspects are relevant from the financial angle? From the financial point of view the relevant dimensions are return and risk. Take another situation in which the firm is considering a financing proposal. The aspects along with such proposal is examined are cost and risk. Since cost is the inverse of return, we find that in this case, too, the basic dimensions are return and risk.
What is the relationship between risk, return and market value of equity? Higher the return, higher is the market value. Higher the risk lower is the market value.
Where the funds raised are too long, it adversely affects the return and where such funds are too less it exposes a higher risk element. Hence there should be a trade off and an optimal decision is to be taken.
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"The Company should use more and more debt capital in its capital structure so as to increase its E.P.S." - Comment
The principal sources of long term capital for a company are:
equity capital debt capital (debentures & term loans)
On the face of it a company may prefer more of debt capital than equity because of the following disadvantages suffered by equity capital:
The cost of this source of finance is very high because the equity investors look for a high rate of return to compensate for the degree of risk assumed. Since dividends are paid out of post-tax profits, there is no tax shield available to the firm on account of this outflow. Public offer of equity capital can result in dilution of the effective control exercised by the existing shareholders.
On the other hand debit capital, like debentures and term loans do not have these disadvantages. Interest paid on these borrowings is tax-deductible, as interest paid is an item of expenditure on the P & L Account. There is no dilution of control of the shareholders. Further, while there is increased profits available for distribution to the equity holders, debt capital further reduces the net volume of equity capital to a lower base and thus the available profit is distributed to smaller range of equity capital. As a result the Earning per share is kept at the maximum
However while there is no statutory requirement for the Company to pay dividend to equity shareholders, the payment of interest on debentures is a statutory requirement, while payment of interest on term loans is a contractual obligations. Consequences of default in either case affect adversely the interests of the company. A larger debt capital increases the burden of repayment of installments and interest and the company may not be able to generate adequate cash flows to meet the same.
Financial prudence requires the Company to ensure a convenient mixture of both equity and debt, which a larger amount of debt capital, based on the repayment capacity. The use of fixed charges sources of funds such as preference shares, debentures and term loans, along with equity in the capital structure is described as financial leverage or trading on equity. The term trading on equity is used because, it is the equity that is used as the basis for raising debt. Financial institutions while sanctioning long-term loans insist that companies should generally have a debt-equity ratio of 2 : 1 for medium and large-scale industries and 3 : 1 for small-scale industries. The debt-equity ratio of 2 : 1 indicates that for every one unit of equity the company has, it can raise 2 units of debt. Increased use of leverage enlarges the risk of equity shareholders by increasing the commitments of the company by way of interest and repayments. The overall factors that should be considered whenever a capital structure decision is taken are:
cost of capital cash-flow projections of the company Size of the company Dilution of control Flotation costs
An optimal capital structure should have the following features.
Profitability- The Company should make maximum use of leverage at a minimum cost Flexibility - The capital structure should be flexible to be able to meet the changing conditions. The company should be able to raise funds whenever the need arises and also retire debts whenever it becomes too costly to continue with the particular source. Control - The capital structure should involve minimum dilution of control of the company. Solvency - The use of excessive debt threatens the solvency of the company
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Both "Under Capitalisation" & "Over Capitalisation" are undesirable and what company should aim at is "Balanced Capitalisation"- comment
Capital expenditure or capital investment represents the growing edge of a business. They are deemed to be very important for three inter-related reasons.
They have long-term consequences. Capital expenditure decisions have considerable impact on what the firm can do in future. Capital expenditure decisions often involve substantial outlays. It is difficult to reverse capital expenditure decision because the market for used capital equipment is often imperfect.
Given the crucial significance of capital expenditure decisions, it is most surprising that firms spend considerable time in planning these decisions and involve top executives from production, engineering, marketing, and so on, in evaluating capital expenditure proposals, as these decisions are too important to be left to financial managers alone.
Every form of Capitalisation whether by way of equity or debt involves incurring a cost. The cost of Capitalisation is to be viewed in terms of the benefits from the investments. Both in respect of "under-Capitalisation" and "over-Capitalisation" the cost incurred does not match with the benefits accruing from the investment. Under over Capitalisation, while there is no additional benefit accruing from the excess investment, it adds substantially to the cost. In Under Capitalisation, there is large erosion of the benefit from investment, due to inadequacy of operating funds.
Once an investment project is proposed, its costs and benefits must be estimated. This is usually done with the help of inputs provided by marketing, production, accounting, and other departments. The role of the financial manager is to keep the exercise focused on relevant variables, coordinate the efforts of various participants in this process, and ensure that forecasts are reasonably balanced and internally consistent. In order to derive the relevant stream of costs and benefits from these projections, the financial manager must bear in mind the following principles.
Cash Flow principle
Costs and benefits must be measured in terms of cash outflows and cash inflows. Cash outflows and not expenses as determined by accounting conventions, are the relevant measured costs, because they represent the flow of purchasing power. By the same token, cash inflows, not revenues as determined by accounting conventions, reflect benefits properly. Incremental Principle
Cash flows must be measured in incremental terms. This means that changes in the cash flows of the firm, which can be attributed to the proposed project alone, are relevant. Long-term funds principle
A project an be viewed from different points of view, like equity point of view, long-term funds point of view, explicit cost funds point of view, or Total funds point of view. In capital budgeting long term funds point of view is commonly adopted. That is, what are the sacrifice by the suppliers of long term funds and what benefits accrue to these suppliers? Interest exclusion principle
When cash flows relating to long term funds are being measured interest on long-term debts should not be considered. The average cost of capital used for evaluating cash flows takes into account the cost of long-term debt. Post-tax principle
Tax payments like other payments must be properly deducted in deriving the cash flows. Put differently cash flows must be defined in post-tax terms. To sum up, the costs and benefits stream is defined as 'Post tax incremental cash flow stream relating to long-term funds'
A balanced Capitalisation exercise should also take into view a proper capital structure for the company, i.e. a proper mix of the long-term finances used by the firm. The objective of the Company must be to mix the permanent sources of funds used by it in a manner that will maximise the company's market price. In other words companies seek to minimize their cost of capital. This is properly referred to as the Optimal Capital Structure.
The use of fixed charges sources of funds such as preference shares, debentures and term loans along with equity capital, in the capital structure is described as financial leverage or trading on equity. The term trading in equity is used because it is the equity that is used as a basis for raising debt. Financial Institutions while sanctioning long-term loans insist that companies should generally have a debit-equity ratio of 2: 1. Increased use of leverage raises the fixed commitments of the company in the form of interest and repayments and thus increases the risk of the equity shareholders as their returns are affected.
An optimal capital structure should the following features:
Profitability
The company should make maximum use of leveraged at a minimum cost. Flexibility
The capital structure should be flexible to be able to meet the changing conditions. The company should be able to raise debts whenever the needs arises and also retire debts whenever it becomes too costly to continue with that particular source. Control
The capital structure should involve minimum dilution of control of the company. Solvency
The use of excessive debt threatens the solvency of the company. In a high interest rate environment, Indian Companies are beginning to realize the advantage of low debt. Companies in the recent past have launched public issues with the sole purpose of reducing debt.
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