How Important is Finance to a Company

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Finance is important to any company, because enough capital ensure the smooth operation of company. Faced many kinds of way to finance, company must choose a reasonable method. Debt can cut down the cost of capital but increase the risk as well. Equity has low risk but high cost. So by analyzing the capital gearing is important. Beside, the WACC also can assess the financial condition.

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As an international mining company, Xstrata pay great attention to the strategy of finance. This report firstly calculate the capital gearing of Xstrata ,then evaluate the capital structure. Secondly, by calculating the WACC, this report analyze the usage of debt and cost of capital. Because the special role of liabilities, so the proportion of debt must be suitable. At last, this report will assess the current source of long-term financing .Large amount of debt will increase the risk of companying the context of capital structure and WACC ,the Xstrata has reasonable financing way.

Introduction

Finance is important to any company, because enough capital ensure the smooth operation of company. Faced many kinds of way to fiancé, company must choose a reasonable method. Debt can cut down the cost of capital but increase the risk as well. Equity has low risk but high cost. So by analyzing the capital gearing is important. Beside, the WACC also can assess the financial condition.

The capital gearing of the Xstrata

As an international mining company, Xstrata pay great attention to the strategy of finance. So it’s important to critically evaluate the company’s current sources of long term finance. For a company, there are many methods to absorb funds .But the relationship between capital structure and financial risk is sensible. So the calculation about gearing is very important.

The debt to equity is high

Capital gearing=long-term debt / shareholders’ fund. It focused on revealing the stability of the financial structure as well as its own funds to the debt risk tolerance. In this company, the indicators are too high, which reflecting the financial structure is not stable. By analyzing the financial statement of Xstrata, especially the balance sheet(appendix), the long-term debt is 25855.Moreover, the structure of non-current liabilities is clearly, it concludes 9 items as follows: trade and other payables ,interest-bearing loans and borrowings ,convertible borrowings, derivative financial liabilities ,other financial liabilities ,provisions ,pension deficit ,deferred tax liabilities ,other liabilities. AS the security of debt, the shareholders’ funds are 22763.So the gearing is 1.136.This formula show the safest condition of capital structure. Because the shareholders’ fund is the own assets of company, it have less repayment risk. Adequate shareholders’ funds can guarantee the financial security. Under normal circumstances, the Lowe equity ratio is popular, which indicate the strong ability of long-term solvency of enterprises and the high level of protection of the interests of creditors. Though the lower the ratio, the smaller the risk company will encounter, companies can not make full use of the financial leverage.

Xstrata has sufficient assets to guarantee long-term liabilities

There is another capital gearing which can be shown in another way that is long-term debt/long term debt and shareholders’ funds. Both data of the long-term debt and shareholders’ fund can be get from the balance sheet(appendix).By calculating, the gearing is 25855/48618=0.531,which was significantly decline. Compared with the first one, this gearing expand its cardinal number. It takes the whole asset as the security of long-term debt. The advantage of it is enhancing the confidence of investor. Because the decrease of gearing can be consider as positive information which indicate a safe financial condition. In other words, it didn’t accurately reflect the real repayment ability of Xstrata.

The debt to total ratio is reasonable

Commonly speaking, there is a gearing which is used very broadly. That is gearing=all borrowing/all borrowing+shareholders’funds. This gearing is also called debt to total assets ratio. The item all borrowing is the sum of non-current liabilities and current liabilities, that is 30915 US$m, and the data can be get from the balance sheet. Then the data about the denominator is the response of total asset, that is 55314 US$m.Then, the ratio is 30915/55314=0.558.This ratio reflect the proportion of debt in total asset, so it show the repayment ability of company and the level of security of interest of creditors. The low level of it means the small debt responsibility .But is also has limitations. For a rational investor, the analyzing of capital structure is very important; especially the relationship between current asset and fixed asset should be paid attention. Moreover, capital structure also affects operational risk. So, an objective attitude is advisable. Compared with industry sector, the conservative consider the 50% is security. Under normal circumstances, the smaller the asset-liability ratio is the stronger corporate long-term solvency a company has. But not all people hold this opinion. If the target is too small it indicates that the use of financial leverage is not enough business. Internationally as asset-liability ratio was 60% fit? In the case of Xstrata, it has an appropriate ratio and is making full use of debt as well.

Then, there is the last method to calculate the gearing .The gearing =long-term debt/total market capitalization. The data can be easily got from the balance sheet. And the total market capitalization is 33000million.So the ratio is 25855/33000=0.783.This result may be minimum among the four formulas. But it has inevitable defects. The data may exaggerate the level of security. In this circumstance, company put itself to guarantee the long-term debt. There is lot of risk in this condition. Generally speaking, this is the baseline a company can accept.

The weighted average cost of capital and capital structure

Two methods to calculate the cost of the capital

Having known the gearing, the company should calculate the Weighted Average Cost of Capital (WACC).By doing this; this report can give a critical evaluation of the current sources of long-term financing. Firstly, the cost of every item is needed. In order to Cleary analyze the capital structure, this report only choose ordinary share as equity item. For Strata company, the current ex-div share price is 363.04p,the dividend is 18US cent/share, because Xstrata’s Board of Directors has decided to waive the final dividend for 2008.Then the growth of dividends should be expected based on the historical data .From 2005 to 2007,the dividend respectively is 25Uscent/share,30Uscent/share,34Uscent/share.Based on this trends, the expected growth rate is 15%.So,the cost of ordinary is22.8% .Beside,retained earnings also have an opportunity cost, and it is wrong to consider it as a free source of finance. Generally speaking, it is equal to the cost of equity.

Having known the cost of equity by method discussed above, there is another mathematical calculation. In many cases, Capital Asset Priming Model (CAPM) was used to calculate the cost of equity. Compared with last method, it considers the systematic risk witch can not be minimized or eliminated easily. Due to this ,it can analyse the cost in a macro-environment .And the formula is: k= Rf + AZA² j (Rm – Rf).Rf means risk-free rate, it can be approximated by the yield to maturity of treasury bills such as short-term government debt .Due to the current yield data, this report choose 4.9% as risk-free rate. For the beta, it can easily get from the report of Xatrata, and it is 2.81.The beta show a relationship between systematic risk and its impact on specific stocks. Generally speaking, the index which beyond 1 means the systematic exceed the market risk .Beside the two rates mentioned above, the most difficult index to decide is the risk premium. The return of market can be approximated by using stock exchange index, such as FTSE 100.But it often over-estimate the risk, so geometric risk premium is recommended. For risk premium, this report gets it by analysing the regular change of it. For the period 1918-1977 ,the risk premium is9%- now seen as too high, and for the period 1900-2001 is was 4.5% but 7.2% for 1951-2001.Then over the period 1926-2002,Ibbotson Associates found 8.4% .Current equity risk premium of 3% to 5%.But in the financial crisis, the return of market is low. Referencing to the return of market, which usually is 4%-7%, this report take 6% as a proxy risk premium. So the cost of equity is 4.9%+2.81*6%=21.76%.

Both of the two methods can calculate the cost of equity. Compared with the first one, CAPM inevitably has disadvantage. Based on the assumption that unsystematic risk can be eliminated by diversified portfolios hold by investor, the only factor infects the cost of equity is index beta. Beside risk-free rate and beta, there is no other sensitive element. Moreover ,if the investment diversification is not enough, the company will face not only the system risk but also the scattered independent risk .In this case, the real existed risk can not reflected by this model, CAPM will underestimate the cost of equity.

Secondly, this report will analyze the cost of debt. By analyzing the balance sheet of Xatrata, this report considers interest-bearing loans and borrowings as the main source of long-term finance. So the cost of capital of long-term bet equals finance cost/interest-bearing loans and borrowings. The data about finance cost can be get from the income sheet (appendix) which is 1147 US$m and another data 16337US$m can be get from the balance sheet. In the same time, the enterprise tax is 30%.So the cost of debt is 4.9%.

The capital structure of Xatrata is reasonable

Based on the balance sheet, both the weight of debt and equity can be get .Because the weight is made by calculating the proportion of debt and equity. So the weight of equity can be reflected by the rate which is issued capital+retained earning/long-term debt+shareholed’s funds. So, the weight of debt is calculated in the someway. Then, the WACC of Xatrata is 12.253%, and its structure is reasonable.43%source of long-term finance is equity capital and 57%source of finance is debt. That means the company has made full use of debt.

The appropriate usage of debt is important

With the context of capital structure and WACC, the evaluation of the long term finance is important. Generally speaking, debt and equity capital is the main source of long-term finance. Capital Structure is the mix of financial securities used to finance the firm. Sometime, the debt-equity ratio reflects the capital structure. So, the balance between share capital and debt capital is important. And the value of a firm is defined to be the sum of the value of the firm’s debt and the firm’s equity. What’s more, there is a relationship among capital structure, cost of capital and the value of the firm. According to traditional theory of capital structure, within the framework of certain liabilities, the increasing of debt will lead the cost of equity increase, but this crease can not offset the deduction of WACC which is caused by debt financing. So it is important to control the limitation. In this limitation, the increase of debt financing can cut down the WACC, which can also increase the value of company. In contrast, the financial risk will increase when the limitation was exceeded. In the same time, WACC will increase and the value of company will drop. According to this theory, there is an optimal capital structure which can get by adjusting the debt ratio. Another theory found by Modigliani and Miller thought that debt can increase the value of company, and the effect is positively correlated. In the case of tax exist in the company, liabilities interest was diminished before tax, which can reduce the tax. In other words, the increased earning caused by the tax saving can totally contribute to the value of company.

But in real word, this situation is not accurate. This financial crisis was partly duo to the wrong way of financing. October24, 2008, the United States, Alpha Bank and Trust shut down, which become the 16th bank collapsed as a result of sub-prime mortgage crisis. In the march of 2008, the first investment bankBear Stearns which collapsed due to the crisis has a high total asset to equity ratio. Whiling the use of debt management can increase return on investment, it also bring high financial risk. Because when there is financial distress in a company, obligations to creditors are not met or are met with and the cost of debt will become considerable with very high gearing. So high level of debt increases the financial risk therefore, firm value can be affected.

In the case of Xstrata, its capital structure is reasonable. Because the WACC was usually used as the tool to decide the investment .Compared with the need rate of return, the WACC is acceptable when it is high than the rate of return. But it is not means the lower the better. The capital structure is also very important. Based on the good capital structure, a company can make full use of capital gearing and keep the low risk as well. In the case of Xstrata, its capital gearing is not very high and the debt to total assets ratio is 53.1%.Compared with industry sector, it is acceptable. Due to the enough capital to ensure the payback ability, Xstrata effectively use debt t finance in the safe financial condition. Beside this, the WACC of Xstrata is low .Based on the reasonable capital structure, low WACC can raise the value of company. But this only means Xstrata has an ability to finance by a mix of debt and equity. In the current economic and financial climate, mortgage and leasing is very common. Finance derivatives are also used as source of finance. But it is difficult to manage and has high risk especially in the financial crisis.

Conclusion

Long-term finance is very important to a company. So the source of long-term finance is should paid great attention. Generally speaking, company finance by using debt capital or shareholder’s funds. So the capital structure must be reasonable. High debt means high risk a company must encounter but it also means a low cost of capital. So a low WACC not must increase the value of company. A good company must have a good balance in the debt and equity capital.

Reference

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How Important is Finance to a Company. (2017, Jun 26). Retrieved August 11, 2022 , from
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