Question

How the firm financed the purchase of its assets?’ Explain the category of ratios used to address the question.

Answer 1

Financing the purchase of assets:

There are three options available to Finance a company's purchase of assets, these are (1), using the equity (2), using the debt and (3), using lease agreement.

Apart from the Equity financing the other options available to finance purchase of assets incurs fixed cost to the company which affects its cashflows and thus have an impact on the working capital of the company.

All the three options discussed above have its own implications for the company.

Equity financing dilute the shareholding of the promoters of the company, a company doesn't have to pay a fixed cost for the raised capital to finance the purchase of its assets.

Debt financing increases the burden on the company in terms of the fixed interest that has to be paid every year. Excess use of debt to finance the purchase of debt can have a serious issue with the working capital of the caompany as well as cashflows of the company.

Leasing the assets gives the firm flexibilty and with some fixed cost a firm can lease an asset for a specified period.

Ratios that are used to address this situation:

Debt-equity ratio: It calculated by dividing total debt of the company by the total equity of the firm.

This ratio is used to know the amount of financial leverage of a company. This ratio also helps, the management of the company, shareholders & lenders of the firm to know the level of risk that the firm have.

Other ratio includes,

Debt to EBITDA ratio: It is the ratio used to determine the amount of income generated by the company and available to pay its debt obligations before considering its interest, taxes & depreciation amortization. High ratio means the company is having too much of debt in its balancesheet thus making it more riskier than the other companies.

Debt to capital ratio: Debt to capital ratio of a company is used to determine the financial solvency and the degree of leverage at a particular point in time. It is calculated by dividing total debt of the company with the total capital of the company.

Interest coverage ratio: The ratio is used to know how easily a firm can pay its interest expenses on the debt outstanding in the balance sheet of the company. It is calculated by dividing EBIT of the firm with the Interest expenses for the same time period.