Question

Consider the following scenario. You just accepted an opportunity to manage and operate a business that you do not know much about. What financial information would you need to analyze the company’s capital structure and how could it be used to advance business operations?

Describes what Capital Structure and capitalization is and why it is important.

Describe and Detail: The sources and value of the various forms of leverage that are used in companies, explaining how any debt, equity, or assets are used to further the business operations. This should include the effect that leverage can have directly or indirectly on operational funds and ultimately on the operations. The overall capital structure, including how equity, namely stocks, is held, other capital resources, and cash.

How each of these items affects operations, positively or negatively, should be discussed. How these can be used to advance the business operations, mostly focusing on how the capital structure affects available funds for operations, such a payroll, inventory costs, marketing costs, cost-of-sales and support etc.

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Answer 1

Following Financial Information would be needed:

1. Debt: Long term and short term loans on the company’s balance sheet
2. Equity: Common Stock/Preferred Stock/Retained Earnings

With this we can calculate the Debt/Equity ratio.

For new operations, when we decide which form of capital should be used, we have to keep the following in mind:

Option 1: Raise debt. Now debt involves fixed repayment in the form of interest, So let’s say the Debt required is 100, and the interest rate is 10 percent. That would mean interest of 10.

Interest Coverage: EBIT/Interest.

No assume that we need atleast Interest coverage of 3x. (Reason: if it is 3 that would mean 33 percent of profit goes for interest payment)

So that implies the company would need EBIT of 3*10 (30).

If EBIT margin is let’s say 10 percent, so Sales required would be 300.

So the question I would ask is can the new business operation generate sales of 300 at 10 percent EBIT margin?

Also, we would have to look at the current capital structure. If the company is already levered then adding extra debt could increase the cost of borrowing.

Option 2: Equity has higher cost but does not have mandatory repayment.

However, for equity, the investors must perceive the company to have adequate value for it to be of worthy investment