Question

Your firm has just acquired a new audit client. The new client is highly leveraged with borrowing from several institutions. It is planning to expand the business by obtaining additional debt finance in the near future. Based on these facts, which one of the following should be most carefully examined?

Answer 1

In the scenario of a highly leveraged new audit client planning to expand through additional debt finance, the auditor should carefully examine the client's ability to meet its debt obligations. This involves a thorough analysis of the financial health, liquidity, and cash flow of the business. The auditor should pay close attention to the client's ability to service and repay its existing debts and assess the potential impact of additional debt on the overall financial stability of the company. This examination helps ensure a comprehensive understanding of the client's financial risks and obligations.

Answer 2

The firm's ability to manage and service additional debt is critical, considering the cash flow, profitability, and creditworthiness. Raising funds through borrowing or issuing stock has its pros and cons, with borrowing retaining control but adding fixed financial obligations and issuing stock diluting ownership. Smaller firms often prefer bank loans while larger firms may issue bonds.

Step-by-step explanation:

When a firm with high leverage is planning to obtain additional debt financing, one crucial aspect that should be most carefully examined is its ability to manage and service the debt. Given that the firm is already highly leveraged, analyzing its current and projected cash flows is essential to ensure that it can meet its debt obligations, alongside interest payments, without compromising its financial stability.

Additionally, assessing the firm's profitability and creditworthiness takes on increased importance, as this influences not only the likelihood of obtaining further debt but also the terms and costs associated with it.

The decision between raising funds through borrowing or by issuing stock depends on several factors. Debt financing can be advantageous for a firm that is looking to maintain control of its operations since it does not involve relinquishing any ownership, compared to issuing stock which would dilute current shareholders' stakes and could subject the firm to the influence of new shareholders and a board of directors.

However, debt financing also comes with the obligation to make regular interest payments irrespective of the firm's income, posing a risk if the firm's cash flow is insufficient.

If a small firm needs a surge of financial capital for a major expansion, the choice between issuing bonds and bank borrowing also becomes relevant, with bank loans typically being more suitable for smaller, personalized borrowings and bond issuances being more common for larger, well-known firms.