The present study is based on the description of financial ratios and sources of finance by considering given aspects of MDM Plc. The study is bifurcated into three parts, first two parts deals with description of profitability and risk assessing ratios to resolve concern of client. Third part of study deals with sources of finance to fund project of €200 million by considering its benefits.
1 Profitability ratios provide information regarding the performance of management by analysing their efficiency regarding the use of business resources (Mathuva, 2015). However, there are several factors influencing profitability ratios which are inclusive of price, quantity, or operating cost, as well the assets purchase or the loan incurred in particular time period. Primary ratios used to assess the profitability of the business is enumerated as below:
Gross profitability ratio is total sales of company subtracted by COGS (cost of goods), then the amount will be divided by total sales revenue, and is expressed in the form of percentage (Sekaran & Bougie, 2016). Gross margin shows the total sales revenue percentage which company keeps after sustaining direct costs related to the selling of goods and services. This ratio shows the trading efficiency of business through which their productivity can be assessed.
Net profitability ratio demonstrates the relationship between net profit (after tax) and net sales. It assesses the company’s total profitability. It is calculated by dividing the net profit after sales with net sales. Practically, net profitability ratio displays the efficient of the organization (Heikal, Khaddafi & Ummah, 2014). Although the best level relies on the business type, thus efficiency can be a judgement by comparing the company with the firms operating in the same industry and with the industry average.
Return on assets shows how beneficial a company is regarding its total assets. ROA provides an idea showing how profitable management is on making use of its assets to produce earnings (Delen, Kuzey & Uyar 2013). It is computed by net income with total assets, ROA is expressed in percentage.
It shows how efficiently management is using its investment in equity. It is considered as the best aspect to indicate profitability. It is computed by dividing net income by owner’s equity. In case the ratio is calculated to be low, then it indicates the weak performance of management (Novy-Marx, 2013). On the other hand, in a situation where the ratio is high, it means that management is performing efficiently with the better use of resources. Further, from the viewpoint of investor, this computing of return on investment determines profit or loss attained by setting an investment during a particular period of time. The formula for computing ROI is Dividends +/Stock Price Change/Stock Price Paid.
Earnings per share are a part of company’s profit assigned Allocated to per basis of share. It is calculated by dividing net income by outstanding shares.
2. The risk of the company can be assessed through evaluating financial ratios of the company. This will provide a description of the capital structure, leverage and solvency of the business. Primary ratio covered in this aspect is enumerated as below:
Debt to equity ratio reviews the company’s capital structure. Corporate with high debts of level mostly notice high equity returns. However there is the existence of risk as the high amount could collapse the firm. The ratio might differ by business, so it is hard to set up guidelines for approvable level of debt (Rackley, 2015). Rather, it is better to observe the direction and ratio trend. Over time, established companies will make more additions in debt to the balance sheet as incomes certainly let them deal with the fixed change. However, this change must be done slowly.
The debt-to-equity ratio is computed by this formula: Total Debt / Total Equity
Interest coverage ratio assesses the security offered to the creditors as it provides a computation of a number of times above EBIT could protect the expense of interest. Over the short-term horizons, this tool is significant rather than equity or debt ratio (Damodaran, 2016). In spite of a corporate supposed to take high-level debts, comfort is provided if there is the capability to repair the debt and alter expense of interest.
This ratio is computed by using this formula: Earnings before Interest and Taxes (EBIT) / Interest Expense
This ratio verifies the EBIT amount and can decline prior to the company facing problems of paying out the annual expenses of interest (Dyba, Gernego & Golub, 2016). It provides a great metric that facilitates to identify the impact of the significant decrease in business to their financial position.
The maximum earnings decline ratio is computed by 1– (1 / Interest Coverage Ratio)
This ratio identifies how much assets of a company are maintained by basis of equity. Reduction in banking sector takes place due to the high leverage ratio of companies. If the bases of assets are high, then it takes a minimum reduction in value in order to abolish equity base and might influence the insolvency of the company (Heutel, 2014). Even as the net result of influence is understandable and clear, the variation b/w business risk and liquidity is fine. Liquidity handles those debts that should be settled in minimum one year, whereas business risk deals with the debt those are to be settled in more than a year (Abdulsaleh & Worthington, 2013). By analysing the overall balance sheet, a business can avoid unpredicted events from having calamitous outcomes.
The financial leverage ratio is calculated by making using of the formula as follows: Total Assets / Total Equity
3. For the funding project of €200 million following options are required to be considered by company:
Equity finance is a suitable option to choose rather than using other sources of finance such as bank loans, as it can put various demands on the management. There are various advantages of equity finance such as the finance is totally committed toward the business and its planned projects (Buckland & Davis, 2016). Investors only appreciate the investment when the business performs well for example, during flotation of the stock market or dealings with new investors. Business does not have to maintain costs of debt funding, bank loans, facilitates to make utilization of the capital for the activities of the business. Exterior investors desire the company to convey values and assist in exploring and executing development and opportunity ideas. Angel investors and venture capitalist can carry out helpful skills and experience to the business (Lee, Sameen & Cowling, 2015). They also help in decision making and strategic planning. Investors often have conferred power in the success of the business that is profitability, development and value increment. They offer to follow up finance as the management grows and develops. There are several disadvantages of equity finance as well, equity finance source is expensive, time-consuming and demanding and might flow the focus of management on the activities of the business. Relying on the investor, a business might lose authority to make decisions. Business is required to invest the time of management in order to offer information regarding investor to examine. There are lawful and rigid issues to comply while raising finance for example promotion of investments.
Various businesses make use of bank loans as an appropriate element of the structure of finance. There is ample availability of bank loans for mature and developed business instead of start ups. There are various advantages of bank loans such as the business is assured the money over time, usually for three to ten years (Grinblatt & Titman, 2016). Loans could be coordinated to the equipment duration or any of the assets the loan is meant for. Though, the interest must be charged on loan, as there is no requirement to offer the bank a business share. Rates of interest are fixed for a certain period of time while making it easy to predict payments of interest (Minsky, 2015). The major drawback of bank loan is security that generally business gives to the bank in exchange of finance. The bank is a safe creditor with security over business assets. If the business fails, then the banks get the first call on regarding the due amount in preference to shareholders. One other disadvantage of bank loan is minimum flexibility.
The significant features of retained earnings are as it contains no cost to the business. Different from other sources retained earnings assists in preventing issue- related costs. It also avoids the probability of vary/intensity of control of current shareholders that lead from the issue of new shares (Damodaran, 2016). The advantages of retained earnings are that it is inexpensive financing source, as it doesn’t engage in any purchase costs. Business does not require paying out any obligation regarding retained costs. It also provides financial stability; it fortifies the financial position of a company ultimately it raise the market value of shares. Lack of Finance is a drawback of retained earnings as the raised amount will be restricted to a particular extent (Brigham & Ehrhardt, 2013). There is another drawback of retained earnings which is high opportunity costs, in this profit has to be sacrifices prepared by equity shareholders. In other words, a retained earnings are dividend foregone by equity shareholders. This sacrifice increases the opportunity cost of retained earnings.
The government offers vast financial support only with one proposal. Businesses which get government grants make it easier to increase monetary from other sources of private and government. These grants can result important and provide immediate business reliability and public coverage (Gritta & Adrangi, 2014). Generally, government grants are on repayment system; the company might face adversity. There is a big requirement of hard work and plenty of planning and researchers.
By considering above described aspects, the company is recommended to generate funds from multiple sources instead of making use of single source for better leverage and capital structure. In case if profits are higher than debt is preferable and if profits are fluctuating then equity is preferable. Due to lack of financial facts, capital structure for funding of new project will be combination of debt and equity. On the basis of this factor, they are required to finance it 60% from equity and remaining from debt.
Conclusion:
In accordance with the present study, the conclusion can be drawn that profitability and solvency ratios assist stakeholders in evaluating financial position through which they can make decisions related to business in a rational manner. Further, sources of finance should be selected on the viable basis by considering pros and cons of each source. For effective funding should be from multiple sources instead of relying on single source.
References:
Abdulsaleh, A. M., & Worthington, A. C. (2013). Small and medium-sized enterprises financing: A review of literature. International Journal of Business and Management, 8(14), 36.
Brigham, E. F., & Ehrhardt, M. C. (2013). Financial management: Theory & practice. Cengage Learning.
Buckland, R., & Davis, E. W. (Eds.). (2016). Finance for growing enterprises. Routledge.
Damodaran, A. (2016). Equity risk premiums (ERP): Determinants, estimation and implications–The 2016 Edition.
Damodaran, A. (2016). Damodaran on valuation: security analysis for investment and corporate finance (Vol. 324). John Wiley & Sons.
Delen, D., Kuzey, C., & Uyar, A. (2013). Measuring firm performance using financial ratios: A decision tree approach. Expert Systems with Applications, 40(10), 3970-3983.
Dyba, O. M., Gernego, I. O., & Golub, S. M. (2016). Management of financial sources for innovative development: foreign countries experience.
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Gritta, R. D., & Adrangi, B. (2014). The Use of Bankruptcy Forecasting Models in Teaching Applied Ratio Analysis in Investment and Financial Statement Analysis Courses.
Heikal, M., Khaddafi, M., & Ummah, A. (2014). Influence analysis of return on assets (ROA), return on equity (ROE), net profit margin (NPM), debt to equity ratio (DER), and current ratio (CR), against corporate profit growth in automotive in Indonesia stock exchange. International Journal of Academic Research in Business and Social Sciences, 4(12), 101.
Heutel, G. (2014). Crowding out and crowding in of private donations and government grants. Public Finance Review, 42(2), 143-175.
Lee, N., Sameen, H., & Cowling, M. (2015). Access to finance for innovative SMEs since the financial crisis. Research policy, 44(2), 370-380.
Mathuva, D. (2015). The Influence of working capital management components on corporate profitability.
Minsky, H. P. (2015). Can” it” happen again?: essays on instability and finance. Routledge.
Novy-Marx, R. (2013). The other side of value: The gross profitability premium. Journal of Financial Economics, 108(1), 1-28.
Rackley, J. (2015). Return on Investment. In Marketing Analytics Roadmap(pp. 71-85). Apress.
Sekaran, U., & Bougie, R. (2016). Research methods for business: A skill building approach. John Wiley & Sons.
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