Page 28 - CIMA SCS Workbook August 2018 - Day 2 Suggested Solutions

SUGGESTED SOLUTIONS

Covenants / security

Lenders often insist on covenants and or security when lending. These can restrict a company’s
activity – effectively the lender becomes a more powerful stakeholder who has greater influence
over the directors’ decisions.

Conclusion

The key issue is that debt finance is cheaper than equity, but it can impose restrictive obligations
that a company might struggle to comply with.

Overall though, it is generally accepted that a company should have a combination of debt and
equity finance in its capital structure. That is it should raise some debt finance to take advantage
of the lower costs, but not have too much debt so that the interest and capital repayments
become too onerous.

Assessing creditworthiness

Introduction

When a company (a borrower) is seeking to raise debt finance, the lender (for example the bank)
will carry out an assessment of the borrower to decide whether to lend. I have first explained the
general factors that lenders will consider, before applying these ideas to FNG’s current position.

Information presented by the borrower to the lender

In order to apply for the debt finance from a bank, a company will have to put together a business
plan. This will contain information such as:

• the purpose, amount and duration of the borrowing
• detailed cash flow forecasts, showing the likely cash flows of the borrower and aiming to
show the lender that the prospects for the borrower are good
• an explanation of how the borrower is proposing to repay the borrowing.

Assessment of creditworthiness by the lender

The lender will then carry out an assessment of the potential borrower by considering the
following information:

Analysis of business plan

The lender will perform a detailed analysis of the business plan. This will include detailed ratio
analysis of both the recent accounts and the forecasts.

The key objective of the lender will be to assess the borrower’s liquidity i.e. whether the cash
flows will be sufficient to make the interest and capital repayments.

The interest cover ratio will be particularly important since it gives an idea of how likely it is that
the firm will continue to be able to meet its interest payments even if profits fall.

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