UNIT 4

Analysis of Financial Statement

UNIT 4
 Financial Statements
 Financial Statement Analysis
 Horizontal Analysis
 Vertical Analysis
 Trend Analysis
 Ratio Analysis
4.1 Financial Statements
4.2 Financial Statement Analysis
UNIT 5 COST OF CAPITAL

DISCUSSION OUTLINE
 Debt Financing vs Equity Financing
 Optimal Capital Structure
 Cost of Capital (WACC)

DEBT FINANCING VS EQUITY FINANCING

DEBT
=
OBLIGATION
DEBT FINANCING

Debt financing is the use of a loan or a bond issuance to obtain funding for a business.
When debt financing is obtained, the business entity incurs an obligation to pay back the funds.
DEBT FINANCING PROS AND CONS
 Has interest payments.
 Has a fixed repayment schedule
 Has first claim on the firm’s assets in the event of liquidation.
 Contains restrictions on operational flexibility
 Has a lower cost than equity
 Expects a lower rate of return than equity.

EQUITY
=
OWNERSHIP

EQUITY FINANCING
Equity financing is when the entity sells an ownership interest to investors. These investors now
own “xx”% of the company and have participation in business decisions going forward.
EQUITY FINANCING PROS AND CONS
 No interest payments
 No mandatory fixed payments (dividends are discretionary)
 No maturity dates (no capital repayment)
 Has ownership and control over the business
 Expects a high rate of return (dividends and capital appreciation)
 Has last claim on the firm’s assets in the event of liquidation
 Provides maximum operational flexibility

DEBT FINANCING VS EQUITY FINANCING SCENARIO

OPTIMAL CAPITAL STRUCTURE
WHAT IS CAPITAL STRUCTURE?

A firm’s capital structure is typically expressed as a debt-to-equity or debt-to-capital ratio.

It refers to the amount of debt and or equity employed by a firm to fund its operations and
finance its assets.

WHAT IS OPTIMAL CAPITAL STRUCTURE?

It is the best mix of debt and equity financing that maximizes a company’s market value while
minimizing its cost of capital.

In theory, optimal capital structure is the proportion of debt and equity that results in the lowest
weighted average cost of capital (WACC) for the firm.
A leverage ratio is a financial measurement that look at how much capital comes in the form of
debt.

IN CONCLUSION, the cost of debt is less expensive than equity. However, there is a limit to the
amount of debt a company should have because an excessive amount of debt increases interest
payments and the risk of bankruptcy. This increase in the financial risk to shareholders means
that they will require a greater return to compensate them, which increases the WACC—and
lowers the market value of a business.
The optimal structure involves using enough equity to mitigate the risk of being unable to pay
back the debt—taking into account the variability of the business’s cash flow.
Companies with consistent cash flows can tolerate a much larger debt load and will have a much
higher percentage of debt in their optimal capital structure.
Conversely, a company with volatile cash flows will have little debt and a large amount of
equity.

Capital structures can vary significantly by industry. Cyclical industries are often not suitable for
debt, as their cash flow profiles can be unpredictable and there is too much uncertainty about
their ability to repay the debt.
While banking and insurance, use huge amounts of leverage and their business models require
large amounts of debt.

COST OF CAPITAL (WACC)

WHAT IS COST OF CAPITAL?
A firm's cost of capital is calculated using the weighted average cost of capital (WACC) formula
that considers the cost of both debt and equity capital.

FORMULA FOR COMPUTING WACC

An extended version of the WACC formula is shown below, which includes the cost of Preferred
Stock (for companies that have it)