Many businesses use debt financing to achieve their financial goals. Debt financing is raising operating capital by borrowing. Scott Equipment Organization is investigating various combinations of short-term and long-term debt financing in financing their assets. Short-term debt financing has a maturity of one year or less; whereas, long-term debt financing has a maturity of more than one year. Short-term debt is usually used to increase the amount of available working capital that can assist the company with its day-to-day operations, such as purchasing a required piece of equipment or to pay suppliers.
Long-term debt generally requires a higher interest rate than short-term debt because the lender is taking on a greater risk by loaning money for a longer period of time. This paper will explore three different financing options for Scott Equipment including aggressive, moderate, and conservative. Calculations will be conducted and compared on the three options to determine the best option for Scott Equipment. Calculations will include the expected rate of return on stockholder’s equity (ROE), networking capital position, and current ratio.
Below is a table showing the results of all calculations. Financial Policy | In mil. | | | Current Assets| 30| | | Fixed Assets| 35| | | Total of Assets | 65| | | Equity Financing| 40| | | Debt Financing| 25| | | | Aggressive| Moderate| Conservative| Short term Debt| 24| 18| 12| Long term Debt | 1| 7| 13| Interest Rate Short term| 5. 50%| 5. 00%| 4. 50%| Interest Rate Long term| 8. 50%| 8. 00%| 7. 50%| Sales| 60| 60| 60| EBIT| 6| 6| 6| Interest | 1. 405| 1. 46| 1. 515| EBT| 4. 595| 4. 54| 4. 485| Tax | 1. 838| 1. 816| 1. 94| Net Income| 2. 757| 2. 724| 2. 691|
Return on Equity | 6. 89%| 6. 81%| 6. 73%| Net Working Capital| 6| 12| 18| Current ratio| 1. 25| 1. 66666667| 2. 5| | | | | Profitability| High| Medium| Low| Risk| High| Medium| Low| Expected Rate of Return on Stockholder’s Equity (ROE) Retrun on equity as defined by Investopedia, (2013), is the amount of net income returned as a percentage of shareholder’s equity; it measures a company’s profitability by revealing how much profit a company generates with the money shareholders have invested.
ROE is expressed as a percentage and calculated by dividing the company’s net income by the shareholder’s equity. The net income is before dividends paid to common stock holders but after a dividend to preferred stock and the shareholder’s equity does not include preferred shares (Investodpedia, 2012). For Scott Equipment’s three financing options there is not much difference between the expected rate of return on stockholder’s equity. The aggressive policy has a 6. 89% ROE, moderate has a 6. 81%, and conservative has a 6. 73%. Networking Capital Position
Networking capital is an important financial tool in evaluating a company’s financial position or stability. It gives one an idea at first glance about the company’s ability to pay off its short-term debts. Networking capital is the difference between the current assets and current liabilities of a company. Positive networking capital suggests the company is able to pay off its liabilities. Whereas, a negative networking capital suggests the company is lacking in liquidity and is not in a healthy financial state. Scott Equipment’s current assets are $30 million.
To figure out their networking capital they need to subtract the current assets from the current liabilities. For the aggressive financial policy the current liabilities or short-term debt is $24 million; therefore, network capital is $6 million. For moderate network capital is equal to $12 million and conservative is equal to $18 million. Scott Equipment needs to monitor their working capital levels; a lack of attention to their investment in working capital of receivables, inventory, and payables can result with a rushed need for cash (“Accounting Tools”, 2013).
For Scott Equipment to continue trading, they have to be in a position to meet their immediate obligations. Current Ratio Current ratio is type of liquidity ratio. It is a financial tool used to measure a company’s ability to pay off its short-term debts with its short-term assets. A company’s current ratio is expressed by dividing its current assets by its current liabilities. A higher current ratio means the company is more capable of paying off its debts. If the current ratio is under one, this suggests the company is unable to pay off its obligations if they were due at that point (Investopedia, 2013).
Companies that have trouble collecting money for its receivables or have long inventory turnovers can run into liquidity problems because they are unable to lessen their obligations. In Scott Equipment’s case all three financial policies show the company to be in good financial health. Aggressive, moderate, and conservative show a current ratio of higher than one. However, the conservative policy is the highest ratio meaning that the conservative approach has the most liquidity and the greatest ability of paying off its short-term debts with its short-term assets. Profitability VS Risk
Risk is defined as the probability that a company will become insolvent and will not be able to meet its obligations when they become due for payment. The profitability versus risk trade off is the balance between the desires for the lowest possible risk for the highest possible return. Low risks are associated with low potential returns and high risks are associated with high potential returns. Long-term funds avoid the risk of increases in short-term interest rates, locking the cost of fund over a longer period of time. This ensures funds are available when needed.
Short-term funds are normally less expensive than long-term funds, but it brings a risk of not being able to refinance for its seasonal needs. A conservative approach uses long-term debt to fund both the seasonal and permanent requirements and an aggressive approach uses short-term debt to fund seasonal needs and long-term debt to fund permanent needs. Conservative approach is considered low risk and low profitability; whereas, the aggressive approach is high risk with higher expected profitability. With the moderate approach the risk and profitability levels fall between conservative and aggressive.
As shown in table for Scott Equipment, the aggressive policy would be high profitability as the net income is higher and the return on equity is highest. The aggressive policy is hig h risk because the current ratio is low suggesting they have lower liquidity and the networking capital is also less. If Scott Equipment decides to use the aggressive policy, this will potentially expose them to reinvestment rate risk and the refinancing may be at a higher rate. Also, they may find themselves struggling to get refinancing for the short-term debt.
Cite this Scott Equipment Organization
Scott Equipment Organization. (2016, Sep 30). Retrieved from https://graduateway.com/scott-equipment-organization/