Financial autonomy PDF Imprimare Email

Financial autonomy and financial leverage

The table below contains the financial balance sheet of a company over a 3 – year period:

Financial balance sheet

1

2

3

Nr.

Assets

Year 1

Year 2

Year 3

1

Intangible assets

10,000

10,000

10,000

2

Tangible assets

50,000

150,000

200,000

3

Financial assets

20,000

20,000

20,000

4

Fixed assets

80,000

180,000

230,000

5

Inventories

50,000

50,000

30,000

6

Accounts receivable

80,000

80,000

50,000

… 7

Costumer receivables

70,000

70,000

40,000

… 8

Other receivables

10,000

10,000

10,000

9

Cash and cash equivalents

130,000

30,000

30,000

10

a) Short term investments

50,000

5,000

5,000

11

b) Cash

80,000

25,000

25,000

12

Current assets

260,000

160,000

110,000

13

Total assets

340,000

340,000

340,000

 

 

 

 

 

Nr.

Equity and Liabilities

Year 1

Year 2

Year 3

1

Equity

250,000

150,000

150,000

2

Long - term debt

10,000

90,000

90,000

… 3

Financial long - term debt

10,000

90,000

90,000

… 4

Non - financial long - term debt

 

 

 

5

Long - term capital

260,000

240,000

240,000

6

Current liabilities

80,000

100,000

100,000

… 7

Financial short - term debt

5,000

15,000

15,000

… 9

Non - financial short - term debt

75,000

85,000

85,000

… - 10

Accounts payable

55,000

65,000

65,000

… - 11

Other operating debt

20,000

20,000

20,000

12

Total debt

90,000

190,000

190,000

13

Total equity and liabilities

340,000

340,000

340,000

 

Tasks: Evaluate the financial autonomy and the financial leverage of the company for the first 2 years.

Steps to follow:

1. Calculate the financial ratios that reflect information about the financial autonomy and the financial leverage for both years (year 1 and year 2).

2. Evaluate the financial autonomy and the financial leverage of the company for year 1 by comparing the calculated values of the ratios to the optimum values.

3. Evaluate the financial autonomy and the financial leverage of the company for year 2 by comparing the calculated values of the ratios to the optimum values.

4. Analyze the dinamics of the ratios.

5. Specify the causes of the dinamics.

6. Offer improvement solutions for year 3.

 

1.       Calculation of the financial autonomy ratio and of the debt ratio for year 1 and year 2

 

Nr.crt.

Financial autonomy

Year 1

Year 2

Year 3

1

Equity

250,000

150,000

150,000

2

Equity growth index

-

60.0%

100.0%

3

Equity growth rate

-

-40.0%

0.0%

4

Total equity and liabilities

340,000

340,000

340,000

5

Total equity and liabilities growth index

-

100.0%

100.0%

6

Total equity and liabilities growth rate

-

0.0%

0.0%

7

Autonomy ratio

73.5%

44.1%

44.1%

8

Autonomy ratio growth index

-

60.0%

100.0%

9

Autonomy ratio growth rate

-

-40.0%

0.0%

 

image001

 

 

 

 

 

 

Nr.crt.

Leverage

Year 1

Year 2

Year 3

1

Total debt

90,000

190,000

190,000

2

Total debt growth index

-

211.1%

100.0%

3

Total debt growth rate

-

111.1%

0.0%

4

Total equity and liabilities

340,000

340,000

340,000

5

Total equity and liabilities growth index

-

100.0%

100.0%

6

Total equity and liabilities growth rate

-

0.0%

0.0%

7

Debt ratio

26.5%

55.9%

55.9%

8

Debt ratio growth index

-

211.1%

100.0%

9

Debt ratio growth rate

-

111.1%

0.0%

 

image003

 

2.       Evaluation of the financial autonomy and financial leverage of the company for year 1

For year 1, 73.5 % of the financing sources are represented by equity, the rest of 26.5% being represented by debt (short – term and long-term debt). This means that 73.5% of the assets are being financed through equity.

The higher the autonomy ratio is, the lower the risks related to dependancy of creditors. Thus, the company attains maximum financial atonomy when liabilities are absent. On the other hand, equity is more costly then debt. Companies use debt as a cheaper financing source to boost their return on equity ratios.

Under these circomstances, in order to evaluate the level of the financial autonomy ratio for the first year, a benchmark is needed. Statistically speeking, the optimum percentage of equity in total financing sources is of 66%. A lower level shows less financial autonomy (more dependancy on creditors) as well as more risks related to the debt. Still, a lower level of financial autonomy reflects higher potential in terms of returns.

A higher level of autonomy shows less return potential (based on the lower leverage), but also less dependancy on creditors and less risk related to debt.

 

3.       Evaluation of the financial autonomy and financial leverage of the company for year 2

For year 2, 44.1% of the financing sources are represented by equity, as the rest of 55.9% are represented by debt. Compared to the structure of the financing sources considered to be optimum, statistically speeking, the state of the company for year 2 can be characterised as more risky. On the other hand, the potential in terms of return on equity is higher.

4.       Dinamics of the autonomy ratio and debt ratios

From the first year to the second, the autonomy ratio decreases by a growth index of 60% (a growth rate of -40%). At the same time, the debt ratio increases from 26.5% to 55.9%. These changes in the structure of the financing sources of the company show an increase of the level of risk, but also an increase of the return on equity potential.

5.       Causes of the dinamics of the autonomy ratio and the debt ratios

Mathematically, the autonomy ratio can decrease (have a growth index of less than 100%) if, from one period to the other, the growth index of the equity is lower than the growth index of the total financing sources. In the case of the company being analyzed, the equity has a growth index of 60%, while the value of the total financing sources stays the same (has a growth index of 100%).

Thus, the reasons for the decrease of the autonomy ratio can be found in the reasons for the decrease of the equity. The equity decreases form one year to the other as profits are distributed in year 2 as dividends.

The financing sources of the company do not decrease, as the decrease of the equity is accompanied by an increase of debt. The total debt increases by a growth index of 211.1%, the main causes of this increase being related to the investment in tangible assets made by the company at the begining of year 2, an investment that is being financed mostly by long – term bank loans. The financial short-term debt increases also, as a result of the increase of the principal payments for the long-term loans.

There is also an increase of the accounts payable, from 55,000 in the first year to 65,000 in the second.

 

6. Improvement solutions for year 3.

The optimum level for the financial autonomy ratio is considered to be 66%. With the level of the ratio for year 2 being of only 44.1%, improvement measures for year 3 should target an increasement of the ratio. In order for the autonomy ratio to increas from year 2 to year 3, the growth index of the equity should be higher than the growth index of the total financing sources (equity and liabilities). Several posibilities are to be considered:

-          Increasing the equity through retained earnings or share capital subscriptions.

-          Decreasing the liabilities by redueing the assets or by replacing the liabilities with equity;

-          Increasing both equity and liabilities, but increasing equity by a higher growth index;

-          Decreasing both equity and liabilities by reducing the total value of the assets, but but maintaing a higher growth index of the equity (altough lower than 100%).

Increasing equity through retained earnings is considered to be the most natural solution. However, there may be times that such a solution is not effective: the company needs to make an investment, for which reason it negociates with the bank for a loan; because of poor financial autonomy, the bank asks for an equity increase, before accepting to grant the loan. In such a situation, there may not be enough time to increase the equity through retained earnings.

In other cases, the company may not be able to generate profits at all, which would impose a drastical solution: either increase shared capital or pay part of the debts by reducing the assets.

 

 

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