F9 Financial Management

2 Designed to give you the knowledge and application of: Section E: Business Finance E1. Sources of, and raising short-term finance E2. Sources of, and raising long-term finance E3. Raising Loan & short-term finance through Islamic financing E4. Internal sources of finance and dividend policy E5. Gearing and capital structure considerations E6. Finance for Small and Medium sized entities (SMEs)

3 Learning Outcomes E5: Gearing and capital structure considerations  Identify and discuss the problem of high levels of gearing. [2]  Assess the impact of sources of finance on financial position and financial risk using appropriate measures, including: [2] i. ratio analysis using balance sheet gearing, operational and financial gearing, interest coverage ratio and other relevant ratios ii. cash flow forecasting iii. effect on shareholder wealth

4 High gearing levels increase the shareholder’s risk refers to using borrowed funds, or debt, as opposed to equity. Gearing Financial GearingOperational Gearing reflects the extent to which fixed assets and associated fixed costs are utilized in the business. Problem of high levels of gearing

5 arises when debt accounts for a large proportion of capital structure Types of Risk Financial RiskBusiness Risk possibility of company experiencing more proportional changes in level of its profits before interest as a result of changes in turnover or operating costs Consequences of high levels of gearing High interest costs resulting in reduced profits Sourcing new finance is difficult Risk of becoming insolvent Higher cost of capital due higher risk Types of Risk

6 SOFP (balance sheet) and Financial Gearing The higher the ratio’s the higher the company’s gearing & its financial risk. Equity gearing Total gearing Income / interest gearing Impact of sources of finance on financial position and financial risk using appropriate measures Continued …

7 Equity gearing Known as debt equity ratio, illustrates company borrowings as proportion to shareholders funds Total gearing illustrates proportion of company ’ s total capital structure i.e. comprised of debt Income / interest gearing illustrates what proportion the company ’ s operating profit will be paid in the form of debt interest Continued …

8 Operational Gearing Shows fixed costs as proportion of variable costs Shows what proportion of total operating costs are represented by fixed costs Shows impact a percentage change in sales will have on profit before interest and taxes Refer to Test Yourself 1 (page 320)

9 Total cash flow coverage ratio Other relevant ratios Debt service coverage ratio (DSCR) A ratio of 2:1 is considered satisfactory Interest coverage ratio (ICR) The higher the ratio better, as company is in a good position to pay fixed interest charge Interest ratio

10 Impact of cash flow forecasting on financial structure and financial position Provides for interest and principal repayments of debt Provides for dividend payments Buy back of shares can be planned only after studying cash flow forecasts Effect on shareholder wealth Dealt with in detail in section G Cash flow forecasting Gives an overall picture of expected cash flows and the nature, timing & extent of any problems arising from them Cash flow Forecasting

11 Recap  Identify and discuss the problem of high levels of gearing. [2]  Assess the impact of sources of finance on financial position and financial risk using appropriate measures, including: [2] i. ratio analysis using balance sheet gearing, operational and financial gearing, interest coverage ratio and other relevant ratios ii. cash flow forecasting iii. effect on shareholder wealth