Accounting & Financial Management Corporate Debt Restructuring

Question: Discuss the management of Equity and Debt as part of the long term funding requirements of companies. (See the marking scheme below). In addition, select two non-financial companies listed on the London Stock Market and analyse the published financial statements for the last 5 years, comparing the proportion of Equity and Debt for each company. This analysis should be based on financial ratios and be clearly linked to the management of Equity and Debt, as discussed above. (See the marking scheme below). Detailed calculations of specific and relevant financial values and ratios must be included, together with appropriate graphs/charts. Your assessment must contain an Introduction, Conclusion and Recommendation detailing the results of your analysis. Answer: Introduction The aim of this report is to analyse the debt and equity financing for business organisations in the context of real world. Marks and Spencer (MS) and Tesco Plc are selected as the two case organizations to discuss the various concepts related to equity and finance. This report includes the debt and equity ratio analysis of the selected organizations. The main purpose of this report is to make a comparison between selected organizations on the basis of debt and equity ratios. Financing is one of the important concerns for operating any business. There are two major sources for financing that are used by companies for meeting their capital need such as equity financing and debt financing. Equity financing refers to raising funds through issue of IPOs and secondary shares in capital market (Brigham and Ehrhardt, 2016). Debt financing refers to the borrowing fund from financial institutions. This fund needs to be repaid by the company at specified time period along with the interest. Most of the companies use these two sources for their course of business. Equity is generally required for the start of business and debt is used for financing current assets that are easily convertible in cash (Bragg, 2011). However, both types of finances are required by the companies for varied purposes. Equity Financing: Under equity financing, a company issues shares in the capital market for raising capital for business. Equity financing is most important at the time of initial stages of business, as early start-up of business seeks huge funds. Financing of funding needs through bank loan can be very costly. For this reason, equity financing matters at initial start-up stage in a company. But at the same time, equity financing has certain limitations like dilution of control, which can impact quality of managerial decisions of company. People like to invest in shares of companies, because they enjoy greater return over their investment as compared to other investment assets. They earn return over investment in the form of dividend offered by company and capital appreciation benefits due to raise in price of share. Equity financing is an appropriate for both Tesco and MS, because there is no need of repayment on principle amount of financing in whole life of company. In addition to this, there is no fixed burden of payment of dividend like in case of debt financing. It is on companys discretion to retain the profit of business for further investment or to distribute the profits in the form of dividends among shareholders. Description/Purpose/Contrast of the Management of Equity: Main purpose of equity finance is to fulfill funding needs of a business entity. It is cost effective source of financing to company as compared to rest of sources such as bank loan, venture capital, hire purchase etc. The purpose of equity source is also to serve investment need of investors. Due to financing decisions of companies through equity, investors get opportunity of investment in IPOs, which is an attractive investment instrument. The ownership of equity shares gives a right to investors to play an essential role in the management of the company. This way, it enables investors to participate in companys decision making process (MS, 2016). Equity is the source through which the investors are granted an ownership. A company may use the funds of investors finance major investment projects as well as to cover the start up cost. In addition to this, company may use this cash flow for diversifying business in other areas. Equity financing is a cost effective source of financing, because investors typically dont expect an immediate return on their investment (Lerner et al., 2012). Further, equity financing is less risky than the debt financing, because the money of investors doesnt needs pay back. There are two methods of equity financing that are used by small business firms such as private placement and the public stock offerings. Private placement is very simple and commonly used source of financing in capital market of UK. Private placements are generally regulated by HMRC and London Stock Exchange. Companies do not require any type of formal registration in the London Stock Exchange (LSE) for use of this source of financing. In contrast of this, financing through public stock offerings is typically a lengthy and expensive process, as it requires for the registration for securities under London Stock Exchange (LSE) and UKLA (i.e. UK Listing Authority) (Laryea, 2010). But public stock offerings may lead to dilution of control in company that is harmful for managerial decision making. Equity financing also plays important role in creditworthiness of a company, as it affects the debt-equity ratio of company. A company, whose debt-equity ratio is less than 1, is considered to be more creditworthy as compared to business entity with equity ratio greater than 1. Companies with high value of debt to equity ratio face high financial cost that is harmful for net profit position of company. Debt Financing: Debt financing can be defined as the activity of financing business needs through borrowing of loans or issue of debt instrument. Financing through debt instruments or bank loan is more costly as compared to equity financing, as the principle amount of loan needs to rapid after a certain period. Along with this, the interest charged by banks is very high. Both MS and Tesco use debt financing as a source of finance for meeting funding need in business. The value of long term debt of MS is 1727000 (in thousands). On the other hand, total debts of Tesco Plc is recorded as 10623000 (in thousands), which is very high as compared to MS (Yahoo Finance, 2016). It means the total debt burden over Tesco is high as compared to MS. Over-dependence on debt financing can be harmful for profitability and sustainability of companies. Description/Purpose/Contrasts of the Management of Debt: Debt financing is an important financial source for meeting the capital needs in business. A debt is helpful to maintain the ownership of business, because it does not lead to dilution of control as in case of equity financing. This source of financing offers tax benefits to the company, because interest expense over debt is a tax deductible expense of company. If a business properly use the debt then it will be helpful to enhance the return on assets (Peterson and Fabozzi, 2012). Selection of debt financing over equity financing offers greater control over business. Lenders charge an interest amount for the use of borrowed amount, but they dont have any right of participation in managerial decisions of company. But for large organizations like MS and Tesco, it is not possible to solely base their business on debt instruments. Debt financing is appropriate for companies that are looking for a growth strategy, and the current debt position of company is very low as compared to equity position. The activity of debt financing includes both long term and short term loan. Generally, short term loan is used by companies for meeting current needs such as operational funding need, and the working capital need. In case of long term loan, business firms focus on raising capital for long term investment needs like investment in machineries, investment in building development, and the investment in furniture/fixture (Weil et al., 2013). There are different business institutions that offer short and long term loans such as bank and commercial lenders, commercial finance companies, and government financing programs. Calculation and Analysis of Ratios of Tesco and MS: Debt and Equity Ratios of TESCO: Tesco is the British multinational company in retail sector. It was founded in 1919 by Jack Cohen. Tesco is the second largest retailer in the world. It is listed on London Stock Exchange. The market capitalization of Tesco is approximately 18.1 billion (in 2015). Debt ratio indicates relationship between the total liabilities and total share holders equity of the company. Low debt to equity ratio indicates lower risk for the company and higher debt to equity ratio indicates higher risk (Tesco, 2013). According to the below calculation, it can be seen that Debt to equity ratio of Tesco is continuously increasing that means companys dependence over debt financing is continuously increasing with time, which is not good for creditworthiness of company. Equity ratio of the company represents the amount of asset that is owned by the investors. In general, a higher equity ratio is favorable for the companies. According to the below calculation, it can be seen that equity ratio of the Tesco is showing fluctuation in the last five financial years (Tesco, 2015). But, overall, the equity ratio of Tesco has decline from 35.25 in 2011 to 15.99. The equity ratio tells about proportion of total assets that are financed by stockholders fund. The decline in equity ratio is not good from companys creditworthiness point of view. Name of the ratio Formula 2011 2012 2013 2014 2015 Debt to equity ratio Total Liabilities/ Total equity*100 107.12 108.48 199.13 232.63 525.21 Total liabilities 17807 20117 33186 34249 37138 Total Equity 16623 18544 16661 14722 7071 Equity Ratio Total Equity/ Total Asset*100 35.25 36.51 33.23 29.34 15.99 Total equity 16623 18544 16661 14722 7071 Total assets 47146 50781 50129 50164 44214 Debt and Equity Ratios of MS: Marks Spencer plc is a British multinational company in the retail sector. It was founded in 1884 by Sir Michael Thomas Spencer. Headquarter of this company is situated at London, UK. MS is listed on London Stock Exchange. It is specialized in selling cloths, home products and luxury food products (Tesco Annual Report, 2012). Debt to equity ratio depicts relationship between total debt and total equity of company. This ratio is used by investors and banking institutions while taking investment decisions and sanctioning loan. The debt to equity ratio of the MS is showing fluctuation in different years, but it has continuously increased in last five year (MS, 2013). Management of MS needs to focus on improving the debt-equity ratio of company for ensuring creditworthiness in the market. Equity ratio is a financial ratio that indicates the portion of total assets, which is financed through equity capital. Equity ratio throws a light on the overall financial strength of the company. A higher equity position of a company indicates the better long-term solvency position of company (Tesco Annual Report, 2014). Equity ratio of MS has been continuously fluctuating from 2011 to 2015. It can be analyzed from below table, that equity ratio of MS has increased from 36.45 in 2011 to 39.01 in 2015. This means, companys reliance on equity capital than borrowed capital has increased, which is good for its creditworthiness in market. Name of the ratio Formula 2011 2012 2013 2014 2015 Debt to equity ratio Total Liabilities/ Total equity*100 174.33 100 202.02 191.94 156.25 Total liabilities 4667 2779 5091 5196 4997 Total Equity 2677 2779 2520 2707 3198 Equity Ratio Total Equity/ Total Asset*100 36.45 38.20 33.10 34.25 39.01 Total equity 2677 2779 2520 2707 3198 Total assets 7344 7273 7611 7903 8196 Graph of Debt and Equity Ratio between Tesco and MS: Comparison of Debt to Equity ratio of Tesco and MS: Generally, the aim of both the companies is to maintain fair debt-equity ratio. This ratio directly affects the financial risk of an organization. Debt-Equity ratio of the Tesco as compared to MS was low in 2011, but it has become very high than MS in 2015 (Tesco Annual Report, 2015). This indicates the decline in competitive credit worthiness of Tesco. It is not good for the investors and lender, because it increases the business risk and cost of financing for Tesco. Debt and Equity ratio of MS is fluctuated between the years 2011 to 2015. It is not a bad thing but it indicates that the debt structure of the MS is not fixed (Marks Spencer annual report, 2012). But, the financial creditworthiness of Tesco is good as compared to MS, because the debt to equity ratio of Tesco is very low as compared to MS. Graph of Equity Ratio of Tesco and MS: Comparison of Equity ratio of Tesco and MS: In above chart, the blue line is indicating equity ratio of MS. On the other hand, equity ratio of Tesco is represented by red line. Equity ratio is measure of the portion of total asset, which is financed by stockholders capital. This ratio is calculated by using the market value of the total assets and shareholders equity. Equity ratio of the MS has increased from 2011 to 2015. In contrast to this, the equity ratio of Tesco has declined significantly from 2011 to 2015, which can negatively affect the public image of company and its credit worthiness in market. It is indicating that company has financed most of its assets through debt financing than equity financing. It can negatively affect the profit position of company due to increased cost of financing activities. Equity ratio of the MS is fluctuated between the 30-40 ranges that mean the equity structure of the MS is not fixed (Marks Spencer annual report, 2014). Overall financial position of MS is better than Tesco. Conclusion From the above discussion, it can be concluded that equity and debt are the main sources of financing for operating business. Based on the financial ratio analysis, it was found that MSs capital structure is highly leveraged as compared to that of Tesco. Debt and equity ratio of Tesco are continuously increasing year by year, which indicates increase in debt burden of company. Additionally, Marks Spencer will face a higher risk due to high value of debt component in its capital structure. On the basis of debt to equity and equity ratio, this report concludes that overall financial position of Tesco is better than Marks Spencer. Recommendation: On the basis of above discussion, it can be recommended to Marks Spencer that it should make some strategy to improve its capital structure. MS has a high leverage ratio that is indicating that the growth of company is funded primarily by debt in the long run. The debt burden on company is very high, which can negatively affect its sustainability in market. This can be improved by focus on equity financing than debt. Along with this, the company should try to increase its sales and profitability through focus on business development strategies. MS may also focus on marketing activities, promotional offers and business diversification strategies for stimulating its growth rate. Reference Laryea, T. (2010) Approaches to Corporate Debt Restructuring. US: International Monetary Fund. Lerner, J., Leamon, A., and Hardymon, F. 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