Determining the Financing Mix and Break-Even Analysis

Posted: August 27th, 2021

Determining the Financing Mix and Break-Even Analysis

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Determining Financial Mix and Break-Even Analysis          

Summary of the Article

Keown, Martin, and Petty (2017) reinforce the need to understand the differences between financial risk, business risk, and operational risk. Whereas business risk entails the variations in the anticipated firm’s earnings resulting from the industry, operating risk is considered the variations in a firm’s operating profits resulting from the cost structure. Unlike the operational and business risks, financial risk is essential in determining the break-even analysis of a firm’s output. Therefore, the break-even concept helps financial managers estimate the quantity of outputs that need to be sold before a firm can cover all the operating costs. Moreover, it is relevant in modeling the firm’s anticipated EBIT (Keown, Martin, & Petty, 2017). Since break-even analysis measures the levels at which total sales equate to total costs, financial managers must understand how operating leverage change based on the fluctuations of both sales and EBIT. 

Keown, Martin, and Petty (2017) discuss how the financial leverage impact the change in EBIT significantly as stakeholders have the liberty to either use preferred stock or debt to finance the firm. Indeed, financial leverage helps define a firm’s capital structure. A capital structure that is heavily funded by debt is considered high financial risk. Therefore, it is understood that a firm that employs high financial leverage exposes the shareholders to high financial risk, especially when the percentage change in EPS to percentage change to EBIT is >1. Thus, both financial and operating leverage significantly impact EPS variations, leading to stakeholders’ risks (Keown, Martin, & Petty, 2017). Designing a capital structure is relevant in establishing both debt-equity composition and debt maturation, primarily through the exception of non-interest-bearing liabilities. Thus, having an adequate capital structure management implies maximizing stock prices while minimizing the cost of capital.

Level of Assets Needed to Operate a Firm

There are various assets that managers can use to run the day-to-day operating activities of a firm. Such types of assets include PP&E, current assets, long-term investments and funds, and intangible assets like R&D. Managers need to differentiate how they can effectively use each level of an asset to help operate the daily business activities. Thus, the choice of a level of asset entirely depends on the calculations of Return on Assets (ROA).

How to Finance Assets or Raise Capital

There are two measures that managers can apply to finance assets or raise capital of a firm. Specifically, there is a choice of equity financing, debt financing, or a combination of the two mechanisms. While debt financing consists of borrowing money, equity financing entails trading off its shares to raise capital. As much as equity financing does not involve imposing a financial burden on the company, it causes the stakeholders to lose control of the firm’s ownership (Keown, Martin, & Petty, 2017). Therefore, a company that has a relatively low debt-to-equity ratio signifies a healthy financial status. 

National Commercial Bank (TADAWUL: 1180)

NCB (TADAWUL: 1180) has total liabilities of 437,475,525 and shareholders’ equity of 68,888,025 million per the financial statement ending 31 December 2019. Therefore, to understand whether the companies financed by debt or equity, the following calculation is done.

Total value of financing = 437,475,525 + 68,888,025 = 507,263,802

% equity financing = 68,888,025/507,263,802 x 100 = 13.58%

% debt financing = 437,475,525/507,263,802 x 100 = 86. 42%

How KSA Vision 2030 Recommends on Resolving Lack of Access to Funds among SMEs

To resolve the lack of access to funds among the SMEs, the Kingdom of Saudi has recommended the launching of Jada investment, a key component of Vision 2030. Notably, Jada’s investment has been critical in providing adequate funding to SMEs via commercially sustainable investments in venture capital funds and private equity. Moreover, there is the creation of SMEA, a body authority with four initiative programs (Alsabhan, 2019). Therefore, SMEA offers to cover for the funding of parties whose have SMEs failed within three years after startup.

References

Alsabhan, A. (2019). Understanding the lack of uptake of entrepreneurial opportunities: The case of Saudi Arabia. RMIT University. Retrieved from https://researchrepository.rmit.edu.au/discovery/delivery?vid=61RMIT_INST:ResearchRepository&repId=12248222050001341#13248404280001341

Keown, J. A., Martin, D. J., & Petty, W. (2017). Foundation of finance. Pearson Education, Inc.