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Financial Ratios for Assessing Capital Structure Decisions

When analyzing financial health and growth potential of a company, one of the business owners and investors depends on the value of the Financial Ratio. And of course what you are looking for is the Financial Ratio that shows how the company’s activities are funded and how effectively the funding is used. In other words, investors want to see how the company optimally and effectively uses its capital structure.

A Brief Definition of Capital Structure

Capital structure is the allocation of debt and equity used by companies to fund operational activities and company expansion.

Equity capital is funds invested by the company owner to the company and retained earnings that represent profits from previous years. Which is where the funds are not distributed to shareholders as dividends. However, these funds are more used for debt financing or business expansion.

While debt capital is a corporate loan fund which is usually in the form of long-term bonds and other debt instruments. And the debt instrument is used to fund the company’s operational activities.

Companies tend to try to optimize their Capital Structure to achieve flexibility and healthier and stronger financial conditions. Optimizing Capital Structure means that a company must achieve certain Financial Ratio values ‚Äč‚Äčthat reflect the use of debt and equity effectively for the survival of the company.

The financial ratio that most reflects the optimization of the Capital Structure is the Debt Ratio to Equity (Debt-to-Equity Ratio) and the WACC (Weighted Average Cost of Capital). The two types of Financial Ratios proved to be very influential in reflecting the optimization of the Company’s Capital Structure based on the results of several studies related to Capital Structure.

Debt Ratio to Equity

As the name implies, Debt Ratio to Equity compares total liabilities or company debt with total financing from its equity. High Debt to Equity Ratios indicate that businesses receive a proportion of debt funding that is greater than their equity funding.

Lower Debt to Equity ratios usually indicate a more financially stable business condition. Unlike equity financing, debt must be repaid to the lender or creditor. Because debt financing also requires payment of loan principal and interest, debt can be a form of financing that is far more expensive than equity financing. Companies that use large amounts of debt may be at risk of not being able to pay off debts and borrowed interest.

Debt Ratio to Capital in the Eyes of Investors and Creditors

Creditors view companies that have high Debt to Equity Ratios will be more risky. This could be because investors don’t want to fund the company as much as funding from creditors. In other words, funds from investors do not have as much portion as creditors. The implication is that investors do not want to fund business operations because the company does not have good performance. Lack of performance may also be the reason why companies seek financing or funding more than debt instruments.

A large amount of debt usage is generally also considered a sign of risky business practices. The rule is that the source of funds for payment or repayment of debt is required regardless of the main income of the business. Companies with high Debt to Equity Ratios and financial performance declines must continue to pay their debts. Even if the business fails to generate enough revenue to cover it, it is also still mandatory to pay off its debt. Of course this can quickly cause a loan to default and end bankruptcy.

In general, lower Debt to Capital Ratios are favored by investors and creditors.

Formulation of Debt Ratio to Equity is:

Total Liabilities / Total Equity

As a simple example, PT Santuy has financial information in the form of total short-term and long-term liabilities totaling Rp120,000,000 and shareholder equity of Rp.230,000,000. Then, the value of the Debt Ratio to the Equity is 0.52.

Weighted Average Cost of Capital (WACC)

The WACC or Cost of Weighted Average Capital is the Financial Ratio that calculates the company’s funding costs for acquiring assets by comparing the debt structure and business equity. In other words, this ratio measures the true weight and cost of debt and the collection of equity funds to fund the purchase of assets and expansion of new capital based on the current level of capital structure of the company.

Management usually uses this ratio to decide whether the company must use debt or equity to finance the purchase of new assets. This ratio is fairly comprehensive because this ratio averages all sources of capital. The sources of capital include long-term debt, ordinary shares, preferred shares, and bonds. And of course this ratio is also very complex. Finding out the cost of debt may be fairly simple.

Long-term bonds and debt are issued with nominal principal and interest rates that can be used to calculate the total cost. But for equities, like ordinary shares and preferred shares, they don’t have a fixed price. And to find out the WACC value, you must calculate the equity price before applying it to the equation.

That is why many investors and creditors tend not to focus too much on this ratio. Estimating the cost of equity is based on several different assumptions that can vary from investor.

1. WACC function

Simply put, the WACC formulation helps management evaluate whether the company must finance the purchase of new assets with debt or equity by comparing the two cost options. Financing the purchase of new assets with debt or equity can make a big impact on the company’s profitability and overall stock price. Management must use the WACC equation to balance stock prices, investor return expectations, and total asset purchase costs. Executives and board of directors use the WACC to assess whether merger decisions are potentially good or bad.

On the other hand, investors and creditors use the WACC to evaluate whether a company is worth investing or given a loan. A high WACC percentage indicates the overall cost of funding a larger company and the company will have less cash to distribute to shareholders or to pay off debt. With the increase in the average cost of capital, companies tend not to create more value for investors and creditors. So that investors and creditors tend to look for investment opportunities from other companies.

2. Complexity of the Application of WACC from the Viewpoint of Financial Analysts

Assume that the company generates an average return of 15% and has an average overall capital cost of 5% every year. The company basically generates returns of 10% for every Rp1 invested or lent. An investor and creditor see that the company will only generate Rp.1.1 for every Rp1 invested. And this Rp. 0.1 value can be distributed to shareholders or used to pay off debts.

When reversed, assume that the company only produces 10% returns at the end of the year and has an average overall capital cost of 15%. This means that the company loses Rp. 0.05 from every 1 rupiah invested because the cost of capital is higher than the return. There are no investors or creditors who are interested in companies like this. Management must work to restructure funding and reduce the company’s overall capital costs.

It is not easy to use WACC as an indicator of financial analysis. Plus there are many different assumptions regarding the cost of equity. That is why many investors and capital market analysts tend to produce different WACC figures for the same company. It all depends on what the estimates and assumptions used by each investor and analyst. This is why many investors use this ratio only for speculative purposes. And they tend to use analytical tools or other financial ratios for more concrete and appropriate investment decisions.

Conclusion

Debt Ratio to Equity and WACC is an analysis tool that has been used by management to look for optimal Capital Structure decisions. By understanding these two ratios, at least both investors, creditors, or management can find out whether the company has used funding sources appropriately and effectively. Regarding the Financial Ratio, you can see the information from the information provided by the Financial Report.

January 13, 2019     0 Comments

Tips for Facing Competition in the Online Business World

The growing digital world makes people able to do anything easily, including doing business. That’s why now online businesses are increasingly mushrooming both small and large scale. Large market share, relatively little capital, easy access to information and substantial profits are usually the reasons. But keep in mind that competition in online businesses is also not playing games. For that you need a separate strategy to overcome them.

Many mistakenly set the first step so that the business cannot develop. There are also those who have started and are running, but due to a lack of exploration and innovation finally the business that was pioneered was abandoned. Therefore, even though an online business offers a lot of conveniences, you still have to have a long-term preparation and plan that is mature in order to remain stable. The following journal summarizes several things that must be done as a first step and what should be done in the future to face online business competition.

Do Research & Determine Target Markets

Online businesses that do not last long are usually caused by inadequate planning at the beginning so the owner is confused about determining the next step for his business. The first step that can be done before doing an online business is to do research and determine the target market. This can be done by conducting research on consumers and competitors. Consumer research is important because it can help find out how consumers behave, whether the business you build is needed and how many consumers.

For beginner business people, simple research can be done through interviews, discussions or most easily with online surveys. You can simultaneously offer products to consumers and ask for their responses. In addition to conducting consumer research, also do research on competitors. With this you can find challenges in the field of online business that is run. Take advantage of data available on the internet to get information about competitors.

Both of these researches will provide an understanding of market conditions and the growth potential of your online business going forward. So you can also know who your business will be aimed at and strategies to compete.

Show Product Uniqueness

The way to deal with other online business competition is to make products and services that are different from others. Pay attention to what competitors don’t offer. Make the products and services that are not available as commodities in your online business. If what you offer is found in the market, try to have other advantages that can be highlighted. Examples are in terms of stronger materials, newer designs or cheaper prices.

Do Branding

Brand is one of the many factors that can determine future business growth, especially in the digital world. By doing your branding is making consumers familiar with the business that is being run. The more familiar the consumer is, the more often your online business is targeted as an option when they need something. This will also foster confidence in the products and services provided. You can do branding through social media, adwords, bazaars and SEO.

Interesting Website

Online businesses rely heavily on the digital world for all their activities, from promotions, sales to customer follow-up in the future. For that, give an attractive appearance on your online website so that consumers are interested in visiting. Apply elegant designs and display interesting product photos. Besides that, build a user-friendly website that is easy for consumers to use.

Product Innovation

Maximum research and branding, if it is not balanced with quality products, the risk of consumers switching to competitors will still remain high. Therefore, the unique and attractive products offered must also be given an increase with various innovations. Always explore your own products and services from the smallest to the largest to improve their quality. Also complete your catalog with more choices so that consumers can find the desired item easily.

Maintaining Consumer Loyalty

In business, business owners do not just pay attention to brand quality and product quality. Business owners must also pay attention to facilities and services to consumers. Because this business is done online, then take advantage of the digital world as much as possible to maintain good relations with consumers. Frequently interact with them. Reply to consumer messages as quickly as possible and answer their questions about your product well. Be friendly, speak politely and patiently is the key to making the buyer king. Follow up on old customers by providing the latest information about your products and services. The impression that consumers get from sellers is also one that makes them want to stay with one product provider.

Giving Discounts, Promotions, Vouchers and Bonuses

Providing discounts, promos, vouchers and bonuses will not make a loss for the business you are running. The benefits obtained will probably be a little in the period of administration. But you also have to see the current and long-term effects that can be produced. Consumers will be more interested in products that are given a discount. Consumers will go to shopping when they have a promo or they have vouchers in certain online stores. In addition, don’t hesitate to give gifts and bonuses to loyal customers to increase their loyalty.

Collaborating with Competitors or Seeking Business Partners

Competitors in business are not just rivals. Competitors can also be one way for businesses to continue to grow. one of them is to establish cooperation or collaboration. Creative and mutually beneficial collaboration with each of your advantages can be a solution to penetrate new market segments. There will be fresh ideas that emerge if you want to open yourself to risk being friends with competitors.

Using Digital Marketing Services

Many business people today use digital marketing services to deal with online marketing problems. With this service, advertising and promotion of your online business can be more optimal because it is helped by increasing visitor traffic. You can use social media, Facebook ads, SEO or Google adwords. the funds spent may be quite large, but this method is usually quite effective.

Honest

No doubt, in the virtual world where producers and consumers do not meet each other, honesty and trust are crucial points. In an online business, consumers will usually pay first before getting the desired goods and services. This is where honesty from business owners is needed to build consumer trust. In addition, you also have to be brave to be responsible if something happens. Sometimes there are things that are a little defective, late delivery, damaged packaging and other problems. You should immediately follow up on this problem or better by providing compensation. Consumers will really appreciate this, can even put high trust in your business.

Those are some things you can do to face competition in online businesses. Competitors are quite a lot, but don’t make it an excuse not to develop. In addition to applying the above, you can also learn from business activists who have succeeded. Because the experiences they have gone through before are a better and more valuable learning.

After the online business runs, proceed with managing finances. For this management it is indeed not difficult but it is also not easy. Moreover, you who do not have basic accounting. But there is no need to worry, because now Journal is present as a solution for managing your business finance. Journal provides user-friendly accounting software with complete features.

October 13, 2018     0 Comments