Question

This chapter explores various accounting issues related to measuring the financing activities of the firm. Both profitability analysis and risk analysis are affected by management’s choice between interest-bearing debt and shareholders’ equity to finance the acquisition of operating capacity. The proper measurement and reporting of liabilities enables the analyst to understand the risk of investing in the firm’s debt and equity instruments, and the existence of off-balance-sheet arrangements complicates the analysis.

Required :

What is financial leverage?

What are the differences between debt financing and equity financing?

What are off balance sheet liabilities?

What is equity based compensation?

What is a variable interest entity?

Answer 1

1. Financial Leverage: This term is used when the additional assets of the organization are financed by making use of debts. It is the use of borrowed funds or money to increase the operations or production of the organization and thereby resulting in an increase in the revenue and sales of the organization. With increase in the debt composition for an organization the financial leverage also increases.

2. a. Equity financing is a method of financing which involves the acquisition of assets by increasing the equity in the organization  which takes shape in the form of issuing additional shares.On the other hand debt financing is a method  of financing which involves acquisition of assets by borrowing money or funds.

2. Equity financing is based on OWN funds and debt financing is based on LOAN funds.
3. In Equity financing there is no responsibility on the investor the investment made in the form of shares whereas in Debt financing there is an obligation to repay the loan amount.
4. Companies where they is a cash problem and therefore lenders find it a difficult proposition to lend are those that are ideal for equity financing whereas Companies that do not have a cash problem are those that go in for debt financing as they have the ability to repay the loans taken with interest.

3.   Off Balance Sheet Liabilities: These are those liabilities of the company that do not find a place in the balance sheet of the organization. Though they don’t figure in the balance sheet of the company they are even then considered as the liabilities of the organization.

3.. Equity based Compensation: This is one of the methods of compensating higher level executives of companies which have only limited resources. This method of compensating the employees would not have an effect on the cash in terms of its outflow. This takes various forms like stock option, stock appreciation rights etc. This method of compensating the employees would have the effect of making them participate in the future growth and success of the organization. This motivates them to commit themselves wholeheartedly in the performance of the organization as they are given share in the ownership through this equity based compensation.