Business Finance Analysis- Scott Equipment Organization - Essay Example

?Running Head: SCOTT EQUIPMENT ORGANIZATION AN ANALYSIS OF THE GIVEN INFORMATION CURRENT ASSETS 30000000 FIXEDASSETS 35000000 SALES 60000000 EBIT 6000000 INCOME TAX RATE 40% SHAREHOLDERS' EQUITY FINANCES 40000000 OF ASSETS REMAINDER OF ASSETS ARE FINANCED BY SHORTTERM AND LONGTERM DEBT Assumption: the ratio of current assets to total assets is financed by the short term debt the ratio of fixed assets to total assets is financed by the long term debt. Policies short term debt long term debt Aggressive 11076923 12923077 Moderate 8307692 9692308 Conservative 5538462 6461538 Aggressive policy cost cost of long term debt = 0.085*12923077 = 1098461.60 cost of short term debt = 0.055*11076923 = 609230.77 Moderate policy cost of long term debt = 0.080*9692308 = 775384.64 cost of short term debt = 0.050*8307692 = 415,384.60 Conservative policy cost of long term debt = 0.075*6461538 = 484615.35 cost of short term debt = 0.045*5538462 = 249230.79 Expected Return on Owners’ Equity Return on equity is one essential type of measure applied in the evaluation of public listed companies. It is found under the series of financial leverage. It measures the rate upon the shareholders’ total accumulated investment value in a corporation. The formula to compute this percentage is given as follows: Net income (per annum) *100 Shareholders’ equity It is from the income statement of a company that this information to compute return on equity is obtained. It is usually dubbed as an artificial measure compared to other types of measurements. Firstly, because the shareholders’ equity has no relationship to the dividends paid to them from the company’s earnings. Secondly, is due to the fact that the shareholders’ equity has no relationship with what such share would be disposed off at in the open capital markets. However, it is not all irrelevant. It is essential as a nature of financial leverage since it shows the earning power of a company. It also enables comparison between companies and eventually in stock selection. (Siciliano, 2003 p111) (A)EXPECTED RATE OF RETURN ON STOCKHOLDERS' EQUITY FINANCING POLICY EBIT(USD) COST OF DEBT(USD) INCOME TAX 40% EAIT EQUITY E.R.O.E (%) AGGRESSIVE 6000000 1707692.37 1716923.052 2575384.578 40000000 6.438461 MODERATE 6000000 1190769.24 1923692.304 2885538.456 40000000 7.213846 CONSERVATIVE 6000000 733846.14 2106461.544 3159692.316 40000000 7.899231 Working capital Working capital is one of the major reasons people need information from the balance sheet of any given company. It is also an expression sometimes referred to as current company’s position. It usually shows in detail the condition, financially, of any business in focus. This communicates to the users by telling them about what would be left in a company’s short term assets subsequent to the payment of short term liabilities. Therefore, if working capital is high, this shows that the company is facing minimal strain financially. By studying the situation of the company as portrayed by this ratio, one can tell if it owns resources vital to make internal expansions or if there is need to borrow. Working capital = current assets – current liabilities (Kennon, 2011) (B) NET WORKING CAPITAL POSITION FINANCING POLICY CURRENT ASSETS SHORT TERM DEBT WORKING CAPITAL AGGRESSIVE 30000000 11076923 18923077 MODERATE 30000000 8307692 21692308 CONSERVATIVE 30000000 5538462 24461538 Current Ratio Current ratio measures the proportion of current assets against current liabilities. Current assets are made up of assets easily convertible into cash and cash. The assets which can be easily converted into cash are those assets which can be sold within a period of one year and such amounts used as a financing source for the day-to-day business operations. Current liabilities are obligations for which the business requires cash in a period of less than one year to fiance. Current ratio simply is a way to show how a firm is able to pay its short term liabilities. Current ratio = current assets Current liabilities {C}CURRENT RATIO FINANCING POLICY CURRENT ASSETS SHORT TERM DEBT CURRENT RATIO AGGRESSIVE 30000000 11076923 2.708333352 MODERATE 30000000 8307692 3.611111245 CONSERVATIVE 30000000 5538462 5.416666215 Expected return In a business where an investor has a stake of more than two assets, it is a possibility to determine the expected rate of return relating to such an investment. Investments where there is more than one asset are called portfolios. The expected rate of return is measured as the weighted average amount of return from each and every asset. A simple formula to express this case is as follows: E(RO) = E (?x + ?y) where; ?= the investment in asset X ?= the investment in asset Y x= the expected return from investment X y= the expected return from investment Y. Risk Any given investment usually has many internalities and externalities that affect it. Sometimes these factors affecting the investments have a negative impact on the returns of the assets at the end of a business period. This effect, from both internally and externally, that affects the investments’ returns negatively, is called a risk. Risk is often measured in the field of finance, using standard deviation. A portfolio’s standard deviation would, therefore, determine the measure of risk involved in investing in such assets in the investment presented. The standard deviation of a portfolio is not a separate case of standard deviations of assets in question, but a combination of the aggregate assets in that investment. The reason while all assets in entirety are put into consideration is that the assets are related in one way or another amongst themselves. This interrelationship is determined using the coefficient of correlation. This coefficient of correlation measure has a range of between -1 and +1. A positive one coefficient of correlation simply implies that assets X and Y are directly related in that the outcomes of any case scenario would move in the same direction. Take for instance, the case at hand and pick an example of an aggressive policy. In that case if assets X and Y while subjected to a certain situation, the outcomes are likely to move in the same direction. The other case of a negative result of the coefficient of correlation would imply the opposite of the aforementioned case of a positive scenario in that, results of X and Y are related but inversely. For example, if X’s returns are increasing thus it should follow that those of Y are dipping. If a two-asset case of investment is considered, then the standard deviation would be measured as per the following formula; Where; ?y= the standard deviation of Y ?=the correlation coefficient of X and Y In all the scenarios of this study, the factor to determine which option of financing to take; whether aggressive, moderate or conservation policy, the rate of return is considered against the standard deviation of the whole assets’ investment. Given the debt rates and the amounts of cost obtained, the figures would be considered against return levels and risk rates. (The Registered Trustees Strathmore Education Trust, 2000pp41-54) Other things in the case remaining constant, the conservative policy would mean the least costs of an investment in terms of debt being obtained and thus in comparison with the expected levels of return; where such return is the same, the conservation policy would be taken. The businesses’ mix of the various sources of capital to finance assets determines the direction in which the business will move. It may take any combination, but the aim of the decisions being made is normally one- market value maximization. The impact of the existing cost of capital would also be looked at because the cost of capital would have a direct impact on the value of the share of this company. Mostly, the cost of debt stands at a lower rate than the equity cost. The reason behind this is the fixed obligation of a debt in comparison to equity. However, it is not possible for businesses to depend upon the debt portion of capital alone. Debt simply raises the risk of a bankruptcy situation. The risk of going bankruptcy is mostly associated with the earnings’ and sales’ instability. A business experiencing a high bankruptcy risk is highly likely expected not to take a big amount of leverage and it might end up not being able to meet its liabilities. Basically, there are two major types of risks; diversifiable and non-diversifiable risk. The diversifiable risk is one which a businessman can get away with if that operation is held in a portifio that has been considered efficient. On the other hand a non-diversifiable risk is a risk that still persists in an entirely diversified portfolio. A rational investor will, therefore, aim at removing in totality the diversifiable kind of risk. Choosing the best portfolio in an investment would call for the analysis of the two main things, thus. The two things are the return part of a business operation and the risk part of it. One of the methods applied by financial experts before to determine the levels of the two is the efficient frontier. The other is the capital asset pricing model. These two would help understand situations where risk is being minimized while returns are being maximized. This case of minimizing risks and maximizing returns simultaneously is an ideal situation for a rational investor. (The Registered Trustees Strathmore Education Trust, 2000pp78,79) With respect to profitability, the aggressive policy would rank as low due to the amount of return on shareholders’ equity, the moderate policy would follow as medium, while the conservative would rank as high. In terms of risk, the aggressive policy would be taken as high due to cost of debt, the moderate policy would be medium while the conservative would rank as low. Reference: Kennon, Joshua. (2011). Working Capital. Retrieved 10th May 2011 http://beginnersinvest.about.com/od/analyzingabalancesheet/a/working-capital.htm The Registered Trustees Strathmore Education Trust. (2000). Financial Management. Distance Learning Centre. Pp41-79. Siciliano, Gene. (2003). Finance for the non-financial manager. Edition illustrated. McGraw-Hill Professional. p111. Stickney, Clyde P. et al. (2009). Financial Accounting: An Introduction to Concepts, Methods and Uses. Edition 13. Cengage Learning. p266. Read More