Question

1. What's the effect on return on equity (ROE) by raising capital through debt? In the response, explain the relationship of ROCE = ROA * Common Earnings Leverage * Financial Structure Leverage. Explain the numerator and denominator for the ratios. How do these capture the cost of debt as well as the amount of debt?

2. When a bank makes a loan they will use account reports to evaluate compliance with the loan and loan terms. Provide at least one example of a term where accounting would play a role/be involved.

Answer 1

(1) Funding a company through debt, rather than selling company stock to attract capital, avoids diluting the stockholders' percentage ownership of the company. However, if there is a large capital position supplied by stockholder investment, the company has a better credit profile. If shareholders assume risk by funding the company with their capital, the company is likely to be more conservatively operated. If the firm finances itself through debt, the creditors shoulder the risk. However, if the debt results in increased earnings, the return on shareholder investment is exponential.

Return on Assets

To calculate return on assets, first find the profit margin by dividing net income by revenues. Then, calculate asset turnover by dividing total revenues by total assets. Finally, multiply profit margin by asset turnover to find ROA. These numbers can be found on the balance sheet and the income statement.

Debt and ROA

Increased debt has the potential to lower revenues as more money is spent servicing that debt. If it is spent to increase production and production leads to significantly increased revenues, increased debt may increase ROA. That depends on whether the debt burden is so costly it cuts into net income. If revenues rise as a result of debt financing of production, but net income falls due to increased expense, ROA declines.

Return on Equity

Return on equity is calculated by dividing annual earnings by average shareholder equity over the year. Annual earnings are listed in a company's annual report. Shareholder equity is listed in the balance sheet. In establishing a true picture of shareholder equity, check the company's quarterly statements to see if shareholder equity has fluctuated during the year.

Debt and ROE

Increased debt increases the leverage factor in a company. During normal or boom times, leverage results in exponential profit returns. During recessions, leverage can result in exponential losses, as well. A large debt burden carries risk because of the reaction of leverage to the prevailing economic conditions. Increased debt favors ROE during boom times but hurts ROE during recessions.