The objective to financial managers is to maximise the return on
shareholders' funds at an acceptable level of risk. This means
that they must consider:
- The most appropriate debt to equity ratio
- The relative cost of equity and debt finance
- The most appropriate mix of short and long-term liabilities in
the total debt.
In making these financial decisions, financial managers will
consider:
- The terms and costs of each option
- The tax implications
- Matching the term and source of the finance to the
purpose
- Business structure
- Gearing.
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Owner's equity finance is a residual claim to the business's
assets, that is, owners' have a claim to the cash flows
generated by the business's activities only after all other
claims have been met, for example, those of creditors. The
advantages of owners' equity financing are:
- Subject taxation considerations, self-funding of capital by
using retention of profits in the business may be the simplest
and most economical method, in terms of costs of funds.
- It has the advantage of no dilution of ownership, because nobody
from outside the business entity is involved in the funding.
Rather, it is the owners who have not taken their full profit
share.
- No borrowing has taken place to obtain the extra funding. Equity
finance does not have to be repaid and there are no interest
payments or other obligations that have to be met.
- Equity funds are of unlimited duration. No outside influences
determine the life span of these funds in normal circumstances
and so they are ideal for very long-term investments.
Disadvantages of owners' equity financing include:
- Equity funds are also required to absorb losses, which is
entirely within the shareholders' funds area of the Balance
Sheet, and without substantial reserves of equity, no company
can sustain losses for long. One of the problems faced by new,
and also established, small businesses is that their equity
bases are too small. If there is under-capitalisation, they are
unable to carry the early losses usually sustained by new
ventures. As new, or small, ventures they are high-risk
businesses, making them less attractive to lenders and forcing
them to rely on owners' equity funds.
- Equity financing is more costly than debt financing because it
is necessary to earn sufficient profits to pay
non-tax-deductible dividends while retaining sufficient profit
to fund future growth.
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Debt finance is raising funds by borrowing. Debt financing has
the following advantage:
- It is tax deductible from income. Tax savings from the use of
debt increases in periods of high inflation, such as occurred in
the Australian economy during the 1970s and 1980s. Debt is
cheaper than equity. In this case of debt funding, the return to
the investor is paid as interest. This is accounted for before
taxation on profits, and thus for every $100 interest paid,
within a company tax rate of say 35 per cent, the effective cost
of funds to the business is $70. On the other hand, with equity
funding, the return to the investor is in the form of dividends.
These are profit sharing, after tax. So the actual payment of
$100 is not reduced by taxation allowances. A further
consideration is that higher risk usually calls for higher
interest or return. A shareholder is at total risk in that not
only might no dividend be received, but other creditors rank
ahead of a shareholder in final distribution of assets. So we
may say that if the business is paying interest rates of 8 per
cent, then an at-risk shareholder may be expecting dividends of
say 12 per cent. Debt funding is therefore very much cheaper to
the business entity than equity funds.
The main disadvantage of debt financing is:
- It increases the financial risk of the borrower.
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Gearing, or leverage, is the ratio between long-term debt and
equity in the Balance Sheet of a business entity.
Interest-bearing debt Debt to equity ratio = ---------------------------------- x 100
Owners' equity The lower this ratio, the lower the gearing. Thus a company with
$1 000 000 in long-term debt funding, and $10 000 000 in
shareholders' funds has a gearing ratio of 10 per cent. This
company is in a strong position with its debts covered nine
times over by the shareholders' funds. The lowest gearing would
be 0 per cent, while the highest is unlimited, though in
practical terms, an investor would be very concerned about a
company with a gearing over 75 per cent. The ideal gearing does
not exist. Rather it will vary from entity to entity, and from
time to time within the same entity. However, the type of
industry in which the business operates has influence on the
appropriate debt to equity ratio. The appropriate debt to equity ratio can have a significant
effect on earnings per share and the capacity to pay dividends
to shareholders. Earnings per share (EPS) is calculated by
dividing the company's net operating profit after tax by the
number of shares on issue. What the investor actually receives
is known as dividend per share, which is the proportion of
earnings actually paid to shareholders.
After-tax profit Earnings per share ratio = ----------------------------
Number of shares
Dividend Dividend yield =
-------------------------- x 100
Share Price Properly managed, gearing can be very useful to a company, by
only if it is making a return on utilised funds greater than the
interest and other charges on the debt funds. If this is not
met, the company will inevitably be driven into insolvency. This
is another perspective on the risk associated with high gearing
- the higher the gearing, the more vulnerable the company is to
interest rate movements.
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team can assist you with issues related to debt and equity
financing, as well as your other Bookkeeping needs.
Complete
and submit the Express Enquiry form on the top right hand side
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