American Home Products - Finance Case Study

Financial Management-II

American Home Products Corporation

The risk of an organization is covered by two kinds of risk: business risk and financial risk. The business risk of an organization relates to the firm’s operation even if it does not take any debt and completely finances its capital through owner’s equity. On the other hand, financial risk is the risk related to the decisions of finance, how much debt should the company take and how much risk it can take.

Business Risk:

As calculated in the excel file attached, the cash to total assets ratio of American Home Products Corporation has been increasing steadily over the years and it has more or less remained over 23% which means that the operations have been running pretty smoothly and the business risk has remained low. AHP’s cash to total assets ratio reached 28.2% in 1981 which is a clear indicator of it having enough cash flow in order to finance its daily operations.

Moving on to return on assets which shows a firm’s ability to cover its operating costs by earning more income. According to the calculation in the excel file, American Home Product Corporation’s return on assets was stable over the years standing at 19.2% in 1981.
This clearly implies that AHP was able to earn sufficient amount of income in order to recover its operating cost.

However, there is some trouble in the paradise since the sales growth rate has been declining over the years after 1978 (when it was at 14.1%) till 8.8% in 1981. This shows that the company has not been able to keep up with its competitors as far as sales are concerned.

Additionally, AHP is a highly risk averse company as is evident from the case given, therefore it has not been developing new products and has been saving on R&D expenses; but it did not realise that this has harmed its sales whose growth has been consistently declining after 1978.

Financial Risk:

The financial risk depends on the amount of debt the company is taking. Currently AHP works on a very low debt model and has almost nil risk. However, going to a debt equity ratio of 30% would increase the level of financial risk and it would further rise if the company expands to move this ratio to 50% or 70%.

The ROE of the firm has been calculated in the excel file for different levels of debt. As is evident, the ROE keeps on increasing as the level of debt increases. So, the firm needs to strike a balance between the ROE and the level of risk it wants to take.

AHP should definitely increase its level of debt from the current level so as to take some advantage of being leveraged, but it should also be careful that the level of debt should not be so high that the risk increases so much that it is unable to handle it.