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Long-term Debt and Short-term Debt

Question:

Discuss about the Accounting for Intermediate Financial Management.

The long-term debts are those that are due for a period exceeding 12 months. In the case of Medical Australia Limited, the long-term debt comprises of trade creditors and payables. The non-current liabilities are the obligations and for the company, it is the long-term debt as they are not due in the present course of time.

On the other hand, the short-term debt comprises of the debts that are due in a short course of time that is within a span of 12 months. The current liabilities of the company such as trade creditors, income in advance, payroll liabilities, accruals, etc are the short-term debts.

The debt structure of the company can be commented with the help of debt-equity ratio. As per standard industrial norms, the debt-equity ratio should not exceed 1. This means that a higher reliance on the debt will affect the performance of the company as more interest payment will be required.

As per the computation of the ratio, it can be seen that the debt-equity of the company stands below 0.50 that means it is in synchronization with the industrial standards as the company does not contain a major reliance on debt.

When it comes to the short-term debts it can be said that the company has utilized more of short-term debts. This implies the company operates with a motto of better operation in the short-term. Such debts are due for payment in a span of 12 months and hence, the company does not have the obligation of the longer term. On the contrary, the long-term debt comprises of the trade payable and provisions that decreased in comparison to the year 2015. This reflects that the company has more involvement in terms of current liabilities in contrast to the long-term liabilities (Medical Australia Limited, 2016).

No long-term debt

As other details are not available, we shall calculate Cost of Equity using Earnings Price Ratio Approach an under:

Cost of Equity = Current EPS * (1+ growth rate)/ Current Market Price per share

                        = 0.30 cents (1+ 0%) / 0.50 cents

                        = 60 %

Growth rate of EPS is negative, hence taken at zero.

The revenue of the company has been showing increasing trends since past years. This can be seen from the revenue figures in the financial statements of the company. With regard to the changes in revenue earnings, EPS, dividends and growth expectations, following facts can be considered:

Debt-Equity Ratio

Revenue - the revenue for the year ending 30th June 2016 have shown an impressive growth as compared to the revenue earnings for the year ending 30th June 2015. The revenue for the year ending 30th June 2016 was $ 12,419,938 as compared to $ 11,510,774 for the year ending 30th June 2015. The growth in revenue earnings has been approximately 8% (Medical Australia Limited, 2016).

Earning- There was no foreign exchange gain in the year ending June 2016. Also, the expenses for the year 2016 have increased as compared to the year 2015 which has reduced the net profits by more than 70 %. The major reason behind the decrease in profits is due to increase in employee benefits and increase in the cost of goods sold. Despite the fact, the sale has increased by 8%, but the cost of goods sold has increased by more than 20%. So all of this has reduced the profits or PBIT to $ 3,85,251 (Medical Australia Limited, 2016).

EPS has gone down drastically in the year 2016 as compared to the year 2015 because EPS in the year 2016 was (3.24)cents which shows that there has been an overall loss in the business. One of the positive signs are EPS calculated as per the continuing business which stands at 0.30 cents. Although this has also reduced around 70% from the year 2015 where the EPS was 1.04 cents per share.

Dividends- Dividend have not been declared during the year, hence no comments can be added for the same.

Growth expectations- the business is expected to grow at a minimum of 8% as per the growth trends of the business. However, there has to be a check on two things mainly- the cost of goods sold and employee benefits (Parrino et. al, 2012).

P/E ratio depicts the price which an investor can pay to invest in a company for earning the

P/E Ratio = Market Price per Share/ Earnings per Share

Market Value per share as on 30th June 2016 was 0.05 AUD

Earnings per share as on 30th June 2016 was 0.03 AUD or 0.30 cents (Medical Australia Limited, 2016)

Hence, P/E Ratio = 0.05/ 0.03 = 1.667 times

Constant dividend Growth rate model cannot be calculated here as the company has not declared any dividend during the year (Parrino et. al, 2012).

There are various factors that influence a company’s stock price such as:

Revenue and Earnings

Mergers & acquisitions

Change in demand for the products

Reviews and rumors about the company

There are varied reasons for changes in share price. In the P/E Approach model, the reason for the change in share price may be due to the decrease in profits and earnings per share of the company due to which the market prices of the shares may go down. If we talk about the dividend growth model, the share price can be affected in future due to no declaration or low declaration of dividends to the shareholders (Scapens, 2012).

The earnings per share as shown in P/E Ratio Approach is the most reasonable value as compared to the market price per share. EPS is 0.30 cents and MPS is 0.50 cents which are quite comparable with each other (Medical Australia Limited, 2016).

Other information that can be used to value the company’s stocks may be –

Dividends(if declared)- dividends are used in the valuation of shares by using models like dividend growth mode, etc hence it is an important information to know if the market prices are to be calculated (Subramanyam & Wild, 2014).

Financial ratios- such as N.P Ratio, Earning per share, etc. can be compared with other similar company to find out the market valuation.

Other factors such as discounted cash flows, P/E Ratio, etc. also help in finding out the market valuation and hence are important information to be preferred.

As there are no preference shares, debentures or retained earnings in the company, hence Cost of Capital is equal to the cost of equity only.

Hence WACC = 60%

Cost of Equity Capital has been calculated using Earnings Price Ratio, where it comes to 60%.

In the calculation of WACC, the tax rate has to be used where there are debentures and preference shares in the company for calculating the cost of debt and cost of preference shares. In the given case, the whole capital structure consists of Equity shares only hence there is no use of tax rate here (Porter & Norton, 2014).

 There is no debt in the company in its capital structure. Hence the cost of debt could not be found out. In general, the difference is due to the difference in interest rate and taxes involved. The cost of equity is generally calculated using dividend growth or CAPM or Earning Price Ratio, etc whereas the cost of debt is calculated using interest rate and tax rate (Peirson et. al, 2015).

Dividends and Growth Expectations

No, the current liabilities should not be included in the cost of capital calculation. In the given case there is only equity capital in the capital structure. These are short-term liabilities and not long-term debts & occur due to trading activities of the business which may be repaid anytime by selling off the stock or repayment received by the debtors (Porter & Norton, 2014). However, payments to equity shareholders, debenture holders or preference shareholders can only be made by selling off a substantial business or shares which may also bring the business to an end or end of a business segment. So current liabilities are short-term which does not affect the cost of equity (Shah, 2013).

The cost of equity is the major part in the calculation of WACC. As the cost of capital is quite high, the company needs to invest its fund keeping in mind the high cost, so that the company is able to recover its cost of capital and other expenses which should be ideally more than the cost of equity.

The capital structure of the company consists of only equity share capital. The cost of capital of the company is very high. So, the company should choose other options also in line with the industry and should include debentures and preference shares also in capital structure (Peirson et. al, 2015). Also, the company should somehow restrict its expenses so that there can be some retained earnings for the company. 

An optimal capital structure is one which has the lowest cost of capital. It can be achieved by a balance between the debts and equity. A structure with more debts generally has a lower cost of capital due to tax deduction available. Hence the company should opt for some debt in its structure as well. The circumstances that can cause a change in optimal capital structure can be demerger of the company, the redemption of the heavy amount of debentures, the market in fluctuation, etc (Medical Australia Limited, 2016).

Going by the financial performance of the company it can be said that Medical Australia Limited performance has fluctuated in the past years. The profitability of the company indicates that the company was not able to operate at full capacity and failed to generate adequate profit. This can be attributed to the market risk that the company faced. Beta is the best measure for the market risk (Kay, 2017). The five-year market beta of Medical Australia is projected at 0.45 that indicates the company is less volatile as compared to others. If the market index changes or varies then that change will have a low change in the price of the stock (Medical Australia Limited, 2016).

Market Valuation

(Kay, 2017)

The beta of MLA indicates that the investors with a portfolio of high beta might view this as irrelevant if they are of the opinion to lessen the exposure to the risk prevalent in the market mostly in times of downturn (Choi & Meek, 2011).

As per the market capitalization of the company that stands AUD $11.35M ranks MLA in the small-cap category of stocks. Moreover, the company contains higher beta as compared to the larger companies. The operation of the company is in the healthcare sector and tends to have low sensitivity to the shocks of the market (Volcker, 2011).  In tune to this, a high beta should be expected for the company but overall a low beta should be present for the healthcare segment. Therefore, it indicates that MLA should be more volatile (Brigham & Daves, 2012).  During the economic downturn, low demand will lead to re-assessment of the production.  The fixed assets of the company constitute only 22.23% of the total assets and the important fact that needs to be noted is that the company does not have a heavy reliance on the costly assets (Medical Australia Limited, 2016). Therefore, the volatility of the company is low and as per the experts, it is a safe investment that is even projected by the beta of the company.

The important fact that needs to be noted about MLA is that the company bears low fixed cost meaning that when it comes to operating leverage, it is flexible when it is a downturn. Hence, MLA can be tagged as a strong bet when it comes to the economic downturn as the beta is low along with the fixed cost (Wagenhofer, 2014). Both the factors provide a strong cushion to the company and hence, is an important element that can be taken into consideration.

Reference:

Brigham, E. & Daves, P 2012, Intermediate Financial Management , USA: Cengage Learning.

Choi, R.D. & Meek, G.K 2011,  International accounting,  Pearson .

Kay, L 2017, Before You Buy Medical Australia Limited’s, viewed 13 October 2017 https://simplywall.st/news/2017/10/10/before-you-buy-medical-australia-limiteds-asxmla-you-should-consider-this/

Medical Australia Limited 2016, Medical Australia Limited 2016 annual report and accounts, viewed 13 October 2017 https://www.medaust.com/irm/company/showpage.aspx?CategoryId=190&CPID=1565&InstanceVersionNumber=0

Parrino, R., Kidwell, D. & Bates, T 2012, Fundamentals of corporate finance, Hoboken, NJ: Wiley

Peirson, G, Brown, R., Easton, S,   Howard, P & Pinder, S 2015, Business Finance, 12th ed, North Ryde: McGraw-Hill Australia.

Porter, G & Norton, C 2014, Financial Accounting: The Impact on Decision Maker, Texas: Cengage Learning

Scapens, R.W 2012,  Commentary: How important is practice-relevant management accounting research? Qualitative Research in Accounting & Management, vol. 9, no.3, pp. 293 – 295.

Shah, P 2013, Financial Accounting, London: Oxford University Press

Subramanyam, K & Wild, J 2014, Financial Statement Analysis, McGraw Hill

Volcker, P 2011,  Financial Reform: Unfinished Business, New York Review of Books.

Wagenhofer, A 2014, The role of revenue recognition in performance reporting, Oxford University Press

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