ACCT10002 Lecture Notes - Lecture 10: Comprehensive Income, Profit Margin, Income Statement
19 Jun 2018
School
Department
Course
Professor
Introductory Financial Accounting
Lecture 10:
Annual Reports, Performance, Measurement and Disclosure; Debt/Equity decisions
Debt versus Equity financing decisions
Debt financing has three major advantages over equity financing:
1. Shareholder control is not affected- noteholders do not have voting rights
2. Tax saving result- as interest is tax deductible while dividends on stares are not
3. Return on equity may be higher- Although interest expense reduces profit, return on shareholders’
equity is often higher under debt financing because equity is not increased by the issue of shares
Other factors to be considered when making the debt/equity decision:
- The liquidity and solvency risk associated with future interest and principal payments;
- Potential changes in interest rates;
- The change in ownership structure under the share issue alternative;
- Profit realization; will it occur; and will it be sustainable?
Higher interest rates lower ROE, lower interest rates increase ROE
Lower liquidity and solvency risks are associated with equity financing, and the change in shareholding and
ownership that would result from the share issue needs to be considered.
When analysing capital structure it is important to understand possible adjustments to Debt and Equity.
-Off balance-sheet financing arrangements – possible increase in debt
-Contingent Liabilities - possible increase in debt
-Convertible Debt/Notes – possible increase in equity
-Preference Shares – treated similarly to debt (fixed dividend and repayment commitment)
Consideration of such items can provide a different measure of Debt and Equity and result in different ratio
analyses.
Du Pont Levels
Level 1: ROA; ROE
Level 2: e.g. Profit margin; Asset Turnover
Level 3: e.g. Receivables Turnover;
Inventory Turnover;
Selling Expenses to Sales ratio
ROA ratio
When Earnings Before Interest and Tax (EBIT) is determined then EBIT is shared between three (3) parties:
1. Banks/financiers (interest payments)
2. Taxation Office (income tax expense)
3. Shareholders (NPAT)
Thus, EBIT is the return generated by management using the assets at their disposal i.e. The basis of
management’s performance.
Financial Leverage Ratio (Capital Structure Leverage)
The level of debt
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Document Summary
Annual reports, performance, measurement and disclosure; debt/equity decisions. Other factors to be considered when making the debt/equity decision: The liquidity and solvency risk associated with future interest and principal payments; The change in ownership structure under the share issue alternative; Higher interest rates lower roe, lower interest rates increase roe. Lower liquidity and solvency risks are associated with equity financing, and the change in shareholding and ownership that would result from the share issue needs to be considered. When analysing capital structure it is important to understand possible adjustments to debt and equity. Off balance-sheet financing arrangements possible increase in debt. Preference shares treated similarly to debt (fixed dividend and repayment commitment) Consideration of such items can provide a different measure of debt and equity and result in different ratio analyses. When earnings before interest and tax (ebit) is determined then ebit is shared between three (3) parties: banks/financiers (interest payments, taxation office (income tax expense, shareholders (npat)
