Debt Finance - Effect of Debt and Equity Finance on the Balance Sheet Flashcards
(14 cards)
Key difference in how equity and debt finance affect the balance sheet?
Equity finance affects both the top half (net assets) and bottom half (equity) of the balance sheet
Debt finance affects only the top half (net assets)
How is equity finance recorded on the balance sheet when shares are issued at nominal value?
Company shows an increase in cash in assets (top half), and an increase in share capital (bottom half), equal to the nominal value of the shares issued.
What additional entries are needed when shares are issued at a premium?
The nominal value is added to share capital, and the premium is added to share premium account (a capital reserve)
XYZ Ltd issues 100 £1 shares at £1 each. What changes are shown on the balance sheet?
Cash (asset) increases by £100
Share capital increases by £100
Net assets and total equity both rise by £100
XYZ Ltd then issues 100 £1 shares at £1.50 each. What entries are made?
Cash (asset) increases by £150
Share capital increases by £100
Share premium account increases by £50
Total equity and net assets increase by £150
How does taking out a loan affect the balance sheet?
- Assets (cash) increase by the loan amount
- Liabilities (loan) also increase
- Net assets and total equity remain unchanged
Why does debt finance not affect shareholder equity?
Because it does not involve issuing shares or receiving equity investment - it is a loan, not a contribution by shareholders
What is gearing?
Ratio of a company’s long-term debt to equity, measuring how reliant the company is on debt finance compared to equity finance
How is gearing calculated?
Gearing (%) = (Lon-term debt/total equity) x 100
What does a high gearing ration indicate?
That the company is more reliant on debt, which increases financial risk but can boost returns in profitable conditions
If a company has long-term debt of £750 and equity of £1,000, what is its gearing?
Gearing = (750 / 1,000) x 100 = 75%
Why might a highly geared company struggle to raise further loans?
Because lenders may view it as a credit risk, having less equity to absorb losses and possibly few unencumbered assets to offer as security.
What is the main benefit of using debt instead of issuing shares?
It avoids share dilution, so earnings per share (EPS) may remain higher.
How is earnings per share calculated?
EPS = profit after tax / average number of ordinary shares in issued
