Effect of Equity and Debt Finance on the Balance Sheet Flashcards
(9 cards)
Which of the following effects does issuing shares at a premium have on a company’s balance sheet?
A. Increases current liabilities only
B. Increases assets and share premium account
C. Increases retained earnings
D. No effect on the balance sheet
B. Increases assets and share premium account
Explanation: Issuing shares at a premium means the company receives more cash than the nominal value, increasing assets (cash) and creating a share premium account (a capital reserve).
XYZ Ltd issues 1,000 £1 shares at £1.50 each. What are the correct balance sheet effects?
A. Assets increase by £1,500, share capital by £1,500
B. Assets increase by £1,000, share capital by £500, share premium by £500
C. Assets increase by £1,500, share capital by £1,000, share premium by £500
D. Assets increase by £1,000, retained earnings by £500
C. Assets increase by £1,500, share capital by £1,000, share premium by £500
Explanation: £1,500 total raised. The nominal £1 per share goes to share capital (£1,000) and the extra 50p per share goes to the share premium account (£500).
Which part of the balance sheet is affected when a company takes out a loan?
A. Equity only
B. Assets and liabilities only
C. Assets and equity
D. Share capital and retained earnings
B. Assets and liabilities only
Explanation: Loans increase both cash (assets) and liabilities (loan payable). Equity is unaffected by debt finance.
A company raises £200,000 by issuing new shares. What changes occur on the balance sheet?
A. Increase in liabilities
B. Decrease in retained earnings
C. Increase in cash and equity
D. No effect on equity
C. Increase in cash and equity
Explanation: Equity increases (share capital or share premium), and cash increases (current asset). There is no effect on liabilities.
ABC Ltd currently has 2,000 ordinary shares and profits of £40,000 after tax. It issues 1,000 new shares. What happens to earnings per share?
A. EPS increases
B. EPS stays the same
C. EPS is diluted
D. EPS becomes negative
C. EPS is diluted
Explanation: More shares mean the same profit is spread across more shareholders, so EPS falls unless profits increase proportionally.
Why might a company choose debt over equity for raising funds?
A. Debt increases share capital
B. Debt results in share dilution
C. Debt avoids dilution of ownership and may improve earnings per share
D. Debt must always be repaid before tax is calculated
C. Debt avoids dilution of ownership and may improve earnings per share
Explanation: Debt allows the company to keep ownership unchanged. If used well, returns from debt-funded investment can increase EPS.
Which of the following best describes the gearing ratio formula?
A. Profit after tax divided by number of shares
B. Long-term debt divided by net assets
C. Long-term debt divided by equity multiplied by 100 percent
D. Total assets divided by liabilities multiplied by 100 percent
C. Long-term debt divided by equity multiplied by 100 percent
Explanation: Gearing measures how reliant the company is on borrowed capital compared to shareholders’ equity.
DEF Ltd takes out a long-term loan of £100,000 and increases cash by the same amount. What is the effect on net assets and shareholder equity?
A. Both increase by £100,000
B. Net assets increase only
C. Equity increases only
D. No change to either
D. No change to either
Explanation: Both an asset and a liability increase equally, so net assets remain unchanged. Debt does not affect equity.
What is the primary risk associated with high gearing in a company’s capital structure?
A. It increases exposure to interest obligations and insolvency risk
B. It reduces short-term liquidity
C. It eliminates dividend obligations
D. It boosts share premium reserves
A. It increases exposure to interest obligations and insolvency risk
Explanation: A high gearing ratio means a company has significant debt compared to equity. This increases fixed interest payments and limits flexibility, making the company more vulnerable during financial stress or poor trading conditions.
