Question

How can two companies with identical P & L statements (identical profitablity) at year end provide different annual returns to each of their investors? Which company is the riskier investment? Discuss some different scenarios that result in different levels of risk in each of the cases. Cite outside articles/material.

Answer 1

Ans- It is not always necessary that the companies who have the same or Identical Profit and Loss statements at the year-end will provide the same returns. It may be possible that a company with an identical P & L structure may provide the same return or may not provide the same and the important reason behind this can be considered as capital structure.

Capital structure is nothing but the way the company finances its overall operation through various sources like equity, debt or combination of various securities. It is possible that companies sources of finance may vary some might have more debt than equity and some have more equity than debt. If a company has used more debt than share capital or company's equity than it increases the financial liability of a company because it has to pay more return than other company which has used share capital for its finances. so if the liability of the company increases the risk will also increase and if the risk is higher then return will also be higher as compared to the other company.

Also If the company has used share capital heavily for its finances then at the time of financial crisis the company may have to liquidate its shares.

Therefore the companies have to use debt and equity wisely and in a balanced way as per the returns of the company.