09 and 10. business accounts and debt finance Flashcards
in respect of which period are financial statements prepared?
each accounting period
what rules apply to accounting periods?
Every business is free to choose its own accounting period
are there any common accounting periods?
- matched to calendar year
- matched to tax year
what are the 2 financial statements prepared in respect of each accounting period?
- profit and loss account
- balance sheet
for the purpose of business accounts, are businesses one or separate from their owners?
separate, for example if an owner puts capital into his business, the business ‘owes him’ that capital.
what is the process by which businesses record money transactions called?
bookkeeping
what is a nominal ledger?
transactions of a similar type (eg the payment of rent and electricity bills by the business) are grouped together
what are the different types of ledgers called (in a general sense)?
accounts
what is the collective name for all of the different ledgers/accounts used by the business?
books
example of dual effect of bookkeeping
if a sole trader purchases an asset
for £5,000:
DR -£5,000 cash
CR +£5,000 assets
over the relevant accounting period, in what ratio should the business’s debits and credits be, and what is this called?
1:1 (equal)
trial balance
what is the trial balance?
- a list of debit and credit balances
- on all of a business’s ledgers/accounts
- as at the end of an accounting period.
Every entry on the trial balance will relate to a ledger, which could be characterised as an asset, liability, capital, income or expense (ALCIE) account. What is an ALCIE account?
- Asset
- Liability
- Capital
- Income
- Expense
Trial balance: Asset:
Something a business owns. A business will have a separate account for each category of asset (eg motor vehicles, cash at bank).
Trial balance: Liability: Something a business owes.
A business will have an account for each different type of liability (eg loans, trade debts owed to suppliers).
Trial balance: Capital:
Usually identifiable as an injection of value from an owner or investor rather than money generated by the business.
Trial balance: Income:
Money earned by the business, usually from a regular source. Each main income source of the business will have a separate account (eg a theatre might record income from ticket sales and from venue hire in separate accounts).
what types of items will be treated as income?
✅ Storage rentals
✅ Refrigeration sales
✅ Transport charges
Trial balance: Expense:
Money spent by the business. Each different type of expense is recorded in a separate account (eg heating and lighting, wages paid to employees, etc).
examples of fixed / capital / long-term / non-current assets
tangible or intangible:
- premises
- equipment / P&M
- motor vehicles
- intellectual property (trademark, patent)
- goodwill
what makes a fixed / capital / long-term / non-current asset?
- tangible or intangible
- must be held by the company for over a year
- must provide some long-lasting benefit to the company
examples of current assets
- cash in bank (cash and cash equivalents)
- debtors (receivables)
- stock
what makes a current asset?
- items that can be quickly turned into cash
-
within one year
includes: - cash
- items owned by the business
- items owed to the business
examples of current liabilities
- trade creditors
- bank overdraft (repayable on demand)
examples of non-current / long-term liabilities
- mortgages
- any term loans
what are net current assets?
current assets less current liabilities
as well as an original capital contribution, a sole trader’s capital account will include what?
the profits the business has retained over the years
what type of account is drawings on the trial balance, and why?
- a capital account
- because it represents transactions between the business and its owner (this is how a sole trader or partner pays themselves a salary).
what do expense accounts not include?
they do not include spending on long-term / non-current assets (e.g., a car, a building)
what is another name for spending on long-term / fixed assets?
capital expenditure
what types of items will be treated as an expense?
items that it will not hold for very long before it uses them up:
expenses
✅ wages
✅ business rates
✅ transport costs
✅ repairs
✅ postage
✅ telephone
✅ stationery
✅ insurance premiums
depreciation:
✅ buildings
✅ plant
✅ motor vehicles
accountant’s fees
legal fees
interest on loan
bad and doubtful debts
sundry expenses
what is the purpose of a year end adjustment?
to ensure that all income and expenditure shown on the final financial statements relate only to the relevant accounting period
what is a profit and loss account?
- income less expenditure throughout an accounting period
- to arrive at a profit or loss figure for that accounting period
how is the relevant period described at the top of a P&L?
- ‘for the period ending on [last day of the period]’
- for the year ended [last day of the period]’.
which two entries from the trial balance are recorded on the P&L?
- income
- expense
which of the following entries from the trial balance are recorded on the P&L?
✅sales - income
✅transport costs - expense
✅postage - expense
❌ cash in bank - current asset
which two entries from the trial balance are recorded on the balance sheet?
- assets
- liabilities
- capital
what time period is covered by the balance sheet?
it is a snapshot on a given date (does not capture a period)
what 2 things does a balance sheet tell us?
- net worth or net asset value (NAV) - top half
- capital invested - bottom half
what is the net asset value (NAV)?
value of assets less liabilities owed
which 2 figures must always be the same on a balance sheet?
NAV and capital
what are the 5 year-end adjustments?
- depreciation;
- accruals;
- prepayments;
- bad debts; and
- doubtful debts
what is depreciation?
a mechanism used to deal with the decline in value, and spread the cost of, fixed / non-current assets
what are the 2 methods of depreciation?
- The straight-line method; and
- The reducing balance method.
how to choose between the 2 methods of depreciation?
shelving - straight-line:
- asset is being used up consistently over its lifespan
- generating a consistent amount of income
van - reducing balance
- much more revenue in its earlier years compared to its later year
which of the 2 methods of depreciation is more common?
straight-line method
what is the straight-line method?
gives rise to the same depreciation charge
what is the reducing balance method?
depreciation charge each year is expressed as a percentage (X%) of the reducing balance
why is the reducing balance method expressed as a percentage (X%) of the reducing balance?
More depreciation is charged in earlier years than in later years, since the net book value of the asset reduces year on year
what is the net book value?
Cost – accumulated depreciation = net book value
(estimate of the current value of the asset to the business)
what is an accrual?
when the business has had the benefit of something in one accounting period, but will not pay for it until the next because, although an expense has been incurred and should be charged against profit in the current year:
by the time the accounts are drawn up, that expense has not been included in the trial balance
(eg an invoice hasn’t been received yet)
what would happen to profits if the accrual year end adjustment is not made?
profits would look artificially high
what is a prepayment?
when an expense is paid for in the current year but all or part of the cost should be charged as an expense for the next accounting period
ie the business pays for something in advance, but does not get the benefit of it until the following accounting period
what would happen to profits if the prepayment year end adjustment is not made?
profits would look artificially low
what is a bad debt?
when a business knows with certainty that it is never going to receive certain receivables
e.g., debtor has gone its insolvency
what happens when a bad debt is discovered?
- the debts are written off
- the debts are removed from the receivables entry in the accounts and entered in a bad and doubtful debts expense account
what happens if no bad debts are written off in a given accounting year?
there will be no bad and doubtful debts expense account
how might bad and doubtful debts expense account be referred to in company accounts?
‘Impairments’
what is a doubtful debt?
when a business suspects that it may not to receive** certain receivables
what are the two ways of ‘being doubtful’ about debts?
- Specific doubtful debts
- General doubtful debts
what is a specific doubtful debt?
A business may know that a particular debtor is in trouble financially or is disputing its liability to pay the debt. The debtor may not have entered into an insolvency process or the dispute may be settled on favourable terms and therefore, the owner of the business has not given up hope (so the debt is not a bad one yet) but the business wants to show that there is a risk that it may not receive the amount owed.
what is a general doubtful debt?
A business may not have any information on a specific debtor but knows that the market generally is not doing well and wants to make a general provision for a
certain percentage of its debtors not to pay what they owe:
eg it is estimated that 5% of its Receivables (or debtors) may not be paid.
what type of ALCIE account is a provision for doubtful debts?
most similar to a liability account (assets are reduced as a result of doubtful debts)
will a business literally set aside
cash in order to make a provision for doubtful debts?
no - this is just an accounting procedure
why are doubtful debts accounted for in the same expense account as bad debts in the P&L (‘bad and doubtful debts’ expense account)?
because a doubtful debt may, in future, be written off as a bad debt and become a real cost to the business
how is the provision for doubtful debts shown as a P&L expense year on year?
only the increase (if any) in doubtful debts is shown in the expense account
how are doubtful debts shown on the balance sheet?
- as a liability on the balance sheet
- matched to the receivables asset account
what are the year end adjustments of a partnership (compared to a sole trader)?
the same
where can the main difference be found between partnership and sole trader accounts?
capital (bottom half)
to correctly show the capital of a partnership on the balance sheet, what additional, intermediate step is required?
profit appropriation statement
what is a profit appropriation statement?
shows how profits for the relevant accounting period are divided between the
partners
what are drawings usually based on?
an estimate of the partner’s share of
expected profits for the year
what happens if a partner draws too much from the drawings?
they could be liable to contribute a
balancing payment back to the partnership depending on the terms of the partnership
agreement
in a partnership, what are the two common accounts held by each partner?
- capital account
- current account
what is a capital account?
long-term capital which represents the partner’s original investment in the
partnership (along with any subsequent investments).
This capital cannot normally be withdrawn.
what is a current account?
capital that can be withdrawn at the partner’s discretion
- the partner’s share of the ongoing business profits
- any drawings that the partner has taken out over the year.
what type of ALCIE account are both the capital account and the current account?
capital
After the profit for the business as a whole has been calculated (ie after the P&L has been drawn up), the partnership profits must be divided amongst the partners. How?
- sums are allocated to individual partners corresponding to any ‘interest’ on their capital or ‘salaries’ due to each of them under the partnership agreement.
- the remaining profit will be distributed to the partners according to an agreed profit share ratio.
how is notional interest different to interest generally?
- ‘interest’ is treated as an expense in the P&L
- notional interest is an appropriation of profit under a different name
what is the rate of notional interest?
The rate of interest would be specified in the partnership agreement
what is notional salary and how is it treated in the P&L?
- the amount of such salary (if any) will be specified in the partnership agreement
- it is really an appropriation of profits
- NOT an expense in the P&L (which is how salaries of employees are represented)
- will be treated as drawings
what are residual profits?
profits remaining after each partner has appropriated the notional interest and/or notional salary (if any) to which they are entitled under the partnership agreement
why do companies prepare accounts?
because they are obliged to do so by statute
does the need to make year-end
adjustments to the trial balance before the P&L and balance sheet can be drawn up apply to companies?
yes, as it does to sole traders and partnerships
can a company choose its own own accounting reference period (ARD)?
yes
what is an ARD?
the date on which the accounts are ‘ruled off’
when is the ARD?
the last day of the month in which the anniversary of its incorporation falls
can a company change its ARD?
yes, provided it complies with s392 CA 2006
when must a private company file its accounts at Companies House?
within 9 months after the end of the relevant accounting reference period.
when must a publiccompany file its accounts at Companies House?
within 6 months after the end of the relevant accounting reference period.
what might bring about changes to the types of company that need to file annual accounts?
ECCTB
what are the 3 main differences in the content of financial statements for companies?
- capital accounts
- tax
- dividends
how are capital accounts different for companies?
the capital of a company consists of:
- called up share capital
- reserves
- retained earnings
why is tax represented on company accounts?
because partnerships and businesses run by sole traders do not have separate legal personality, and therefore do not pay tax.
however, companies pay corporation tax which is shown on the P&L and will ultimately affect profitability
how are dividends represented on company accounts?
statement of equity or statement of changes in equity
because they are transactions between the company and its shareholders
why are dividends represented on company accounts?
because:
- The owners of companies are shareholders
- Shareholders’ return on their investment
is the dividend that they may receive.
-
what is the company equivalent of drawings for a sole trader or partnership?
dividends (for a shareholder / owner)
what does the statement of changes in equity (SoCiE) show?
shows the profits brought forward and added to the current year’s profits, subject to any deductions being made for dividends (= retained earnings)
what happens to retained earnings in the following accounting period?
the retained earnings are carried forward to the next accounting period
do subsidiaries prepare individual accounts?
In principle, every subsidiary in the group has a duty to prepare its own individual accounts, but exemptions are widely available, so it is likely to be rare in practice
what is found in the bottom half of a company’s balance sheet?
- Called up share capital
- Share premium account
- Revaluation reserve
(** capital redemption reserve (CRR)*)
what does the share capital account tell us?
- the aggregate amount that has been ‘called up’ (ie the amount of the nominal value of its shares that the company has required its shareholders to pay)
- on each class of issued shares
- not including any premium
what does the reserve account tell us?
Reserves are the capital of the company in excess of the called-up value of the issued share capital
what are the 2 categories of reserves?
- capital reserves
- revenue reserves
what are some examples of capital reserves?
✅ share premium account
✅ revaluation reserve
✅ capital redemption reserve
what are some examples of revenue reserves?
✅ retained earnings
can capital reserves be distributed by way of dividend or other payment to shareholders?
no
can revenue reserves be distributed by way of dividend or other payment to shareholders?
yes, they are distributable
what is the share premium account?
the difference between nominal value of shares and the subscription price (what shareholders actually paid) (if greater)**
what impact does the market price of the shares have on company accounts once issued?
- no bearing at all
- share premium account remains unaltered
is the share premium distributable?
no, except in exceptional circumstances such as a bonus issue of shares
what is a revaluation reserve?
created when a company’s directors, as a matter of accounting policy, wish to show more up to date values of non-current assets in the accounts
eg if the value of its real property portfolio has increased
what item in the top half of the balance sheet does a revaluation reserve (bottom half) correspond to?
non-current assets / net assets
what does a revaluation reserve represent?
a notional profit from the rise in value of the asset
however, the profit is not realised until the asset is sold
when will the notional profit from the rise in value of the asset be realised as a profit and therefore distributable as a dividend?
when the company sells the asset and realises the profit
if there is a subsequent reduction in a re-valued asset’s value, what can this be set off against?
the revaluation reserve
what does retained earnings represent?
- it is the reserve account for retained profits
- represent profits after tax earned by the company over its history
- not distributed by way of dividend
- not appropriated to another reserve
how is the SOCIE broken down?
- brought forward
- profit for the year
- dividends paid
which accounting periods are dividends paid or payable?
out of profits generated in the current or previous accounting periods
when can a company make a dividend distribution?
any time, provided it has profits available for the purpose
what type of ALCIE account is a dividend?
capital
because they are transactions between the business and the owner(s)
on which of the financial statements do dividends appear?
✅balance sheet (capital)
❌profit and loss
what are the 2 types of dividend paid on ordinary shares?
- A final dividend - declared after the year end and paid some time thereafter
- An interim dividend paid during, and in respect of, the current accounting period
who decides the size of the final dividend?
- recommended by the directors in the Directors’ Report
- declared by the shareholders by ordinary resolution
what is a proposed dividend?
If the directors have recommended a final dividend, but the shareholders have not yet approved it
when does a dividend become an enforceable debt?
A proposed dividend does not constitute a debt enforceable by the relevant shareholders until it is approved ie declared by an ordinary resolution
of the shareholders
example of final dividend in company accounts
A company with an accounting period of a year ending on 31 December 2023 wishes to pay a final dividend in respect of that accounting period.
The directors of the company tell you that the final dividend will be approved by an ordinary resolution of the shareholders at a general meeting which is due to take place in April 2024.
If the final dividend is declared by ordinary resolution at the general meeting, it will appear in the accounts for the period ending 31 December 2024.
what is a declared dividend?
A final dividend that has been approved by the shareholders
it is enforceable by the relevant shareholders
how is a declared dividend represented on the SOCIE?
deduction from retained earnings
what happens if the declared dividend has not yet been paid to shareholders by the time the accounts for that year have been prepared?
appears in:
- balance sheet as current liabilities
- SOCIE at the year end
what happens if the declared dividend has been paid to shareholders by the time the accounts for that year have been prepared?
appears in:
- SOCIE at the year end only
where do directors derive the power to decide to pay interim dividends?
normally the articles of a company (eg MA 30)
if the company articles already provide for the payment of interim dividends by directors, what board and/or shareholder approvals are required?
❌ no ordinary resolution of shareholders needed
✅ only board resolution needed
why is an unpaid interim dividend NOT an enforceable debt by the shareholders?
because any Board resolution to pay an interim dividend may be rescinded
before the interim dividend is paid
when will interim dividends be reflect in a company’s accounts?
only if they have actually
been paid
if interim dividends are indeed paid, how will this be represented on the trial balance?
the amount of the dividend will
have been deducted from the assets (i.e. cash and cash equivalents)
if interim dividends are indeed paid, how will this be represented on the P&L?
dividends are capital / an allocation of profit - not an expense of the company - so will not be shown on the P&L
they will be shown on SOCIE
what happens to any profits after tax not paid to shareholders as dividends?
appear as retained earnings
what 2 things must a company consider to ensure that there are no restrictions
- consider when the company was incorporated - check the company’s Articles
what are the **2 classifications ** of debt finance?
- loans
- debt securities
what is a debt security?
- the company issues a security acknowledging the investor’s rights, in return for finance from the investor
- kept or sold onto another investor
- at the maturity date of the security, the company pays the value of the security back to the
holder
what is security for a debt?
collateral
for a debt:
temporary ownership, possession or other proprietary interest in an asset to ensure that a debt owed to a lender is repaid
types of loan facility
- overdraft
- term loan
- revolving credit
what is an overdraft?
- repayable on demand
- interest payable on the amount overdrawn
what is a term loan?
- loan of money for a fixed period of time, repayable on a certain date.
- lender cannot demand early repayment unless the borrower is in breach of the agreement
- lender will receive interest on the loan throughout the period.
what are the 2 ways a term loan can be repaid?
- ‘bullet repayment’ - repayable in a lump sum
- ‘amortising’ - repayable in instalments
what is a revolving credit facility?
- loan for a specified period of time
- borrower can repeatedly borrow and repay up to the agreed maximum
- keeps interest payments down
what is a convertible bond?
can be converted into shares in the issuer
why are preference shares often called a hybrid, even though they are equity?
it has elements that
make it look similar to debt:
- preference shareholders commonly have no voting rights
- usually get a definite amount of dividend ahead of other shareholders (similar
to interest)
- (If the preference share has a fixed maturity date) on which the company must redeem or purchase the share and/or such preference dividend is fixed
what are the main debt finance documents?
- Term sheet - not intended to be legally binding
- Loan agreement
- Security document
what are the 2 meanings of debenture?
- any form of debt security issued by a company, including debenture stock, bonds and any other securities of a company, whether or not constituting a charge on the assets of the company
- one of the most common security documents, which sets out details of the security and is a separate document from the loan agreement.
which debt finance agreements are sent to Companies House for registration?
debenture
what are representations and warranties in a loan agreement?
- statements of fact as
to legal and commercial matters made on signing of the loan agreement - repeated periodically during the life of the loan
what is an undertaking / covenant in a loan agreement?
- promises to do (or not do) something
- to procure that something is done (or not done)
what is an Event of Default in a loan agreement?
breach of representations or undertakings give the bank contractual remedies where the breach constitutes an Event of Default
an Event of Default may give the bank power to call in its money early
type of security?
- pledge
- lien
- mortgage
- charge
what is a pledge?
The security provider (usually the borrower or occasionally another company in the borrower’s
group) gives possession of the asset to the creditor until the debt is paid back
eg pawning a watch
what is a lien?
the creditor retains possession of the asset until the debt is paid back
eg mechanic’s lien
what is a mortgage?
- security provider retains possession of the asset
- but transfers ownership to the creditor (unless it is a charge by way of legal mortgage)
what is a charge?
- security provider retains possession of the asset
- equitable proprietary interest is created in favour of the creditor
- charging document gives the lender some contractual rights (e.g., appointing a receiver or administrator to sell; taking possession itself to sell)
what is a fixed charge?
creditor can control what the security provider can do with the assets
❌ not to dispose of
❌ not to create further charges over
✅ can use the asset for its business
over what assets is a fixed charge often taken?
- machinery
- vehicles
what is a floating charge?
- ‘floats’ over the whole of a class of circulating/fluctuating
assets - security provider is free to dispose of the asset until crystallisation
when does crystallisation occur?
- by operation of law
- breach of certain terms (eg insolvency)
when will a floating charge have priority over a fixed charge?
if the floating charge document contained a term prohibiting the creation of a later fixed charge (a ‘negative pledge’ clause),
but the company nevertheless created a
later fixed charge,
the floating charge will have priority if the later fixed charge holder had
notice of this restriction
what is the significance of 15 September 2003 for floating charges?
in liquidation, funds from proceeds of the sale of business assets will flow to the prescribed part fund for unsecured creditors before flowing to floating charges made on or after this date
what are some disadvantages of floating charges?
- As the security provider has freedom to dispose of the assets in the ordinary course of business, the creditor will not be sure of the value of the secured assets – for example, the
stock might all have been sold before crystallisation occurs. - There is a statutory order of priority of payment of creditors if a company is wound up. A
floating charge generally ranks below a fixed charge (and note that crystallisation does not
change that) and below preferential creditors when the company’s assets are realised (ie sold) and the proceeds of realisation (ie the sale) applied to creditors on the winding-up of the company. However, if the floating charge document contained a term prohibiting the creation
of a later fixed charge (a ‘negative pledge’ clause) but the company nevertheless created a
later fixed charge, the floating charge will have priority if the later fixed charge holder had notice of this restriction. - Floating charges created on or after 15 September 2003 are subject to a part of the proceeds of the assets being set aside. This is known as the ‘prescribed part fund’ for unsecured
creditors. - Floating charges are capable of being avoided under s 245 Insolvency Act 1986 which is looked at in the insolvency chapter on voidable transactions.
- An administrator is free to deal with floating charge assets in their control without reference to the charge holder or the court and to pay their remuneration and expenses out of the
proceeds of those assets. Administration is one of the insolvency procedures which will be examined in a later chapter.
what is a guarantee?
an agreement that the guarantor will pay the
borrower’s debt if the borrower fails to do so
who can give a guarantee?
- companies
- individuals (such as directors)
what is a downstream guarantee?
given by: parent
given to: subsidiary
what is a upstream guarantee?
given by: subsidiary
given to: parent
what is a cross-stream guarantee?
given by: subsidiary
given to: subsidiary
what is an example of when guarantees are often useful?
newly incorporated companies without substantial assets, but with owners that have valuable assets
formalities for registration of charges
the ‘Registrar’ shall register any security created by a company at Companies House, provided that the company or any person interested in the charge (ie lender) delivers to Companies House (electronically or by paper filing) within 21 days beginning with the day after the day the charge was created:
- A section 859D statement of particulars set out on Form MR01 detailing:
- The company creating the charge,
- The date of creation of the charge,
- The persons entitled to the charge, and
- A short description of any land, ships, aircraft or intellectual property registered (or required to be registered) in the UK which is subject to a fixed charge; - A certified copy of the charge; and
- The relevant fee.
do charges created by an English company over assets located both within the UK and abroad need to be registered at Companies House?
yes
what is conclusive evidence that the charge has been correctly registered?
The Registrar must issue a
signed/authenticated ‘certificate of registration’
what is the effect of failure to register a charge:
- at all?
- on time?
- the charge is void against a liquidator, administrator and **any creditor
- the debt becomes immediately payable
in relation to charges, what must a company keep available for inspection?
- a copy of every charge; and
- a copy of every instrument that amends or varies any charge
where must a company keep copies of charges and copies of amendments/variations to charges?
- company’s registered office;
or - such other location as is permitted under the Companies (Company Records) Regulations 2008
who must be notified of the location of these copies of charges and amendments/variations to charges?
Companies House
who can view copies of charges and amendments/variations to charges?
- any creditor - free of charge
- shareholder - free of charge
- any other person - payment of a prescribed fee
what happens if a company fails to comply with the requirements to keep copies for inspection of copies of charges and amendments/variations to charges?
- court may order immediate inspection
- it is an offence
- the company and every officer in default will be liable to a fine
what are the rules of priority among secured creditors?
if more than one creditor has a fixed or floating charge over the same assets:
the first fixed charge created and properly registered has priority
how can the general rules of priority among secured creditors be varied?
through a Deed of Priority, an Intercreditor Agreement or a Subordination Agreement
Shareholders, unsecured and preferential creditors rank equally among who?
themselves, within their category (subject to any preferential rights attached to some shares)
eg *for the category of unsecured creditors, it does not matter when the debt was incurred, because as no one unsecured creditor will take priority within that category
general rule re equity in the balance sheet
top half (x1) + bottom half (x1)
top half: NAV changes
bottom half: total equity changes
general rule re debt in the balance sheet
only top half (x2):
- liabilities increase ⬆️
- current assets (cash) increase ⬆️
i.e., net assets stay the same, because the changes cancel each other out
what changes appear in the balance sheet when a company issues shares at nominal value (shareholder pays same amount as the share was issued for)?
top half (x1) + bottom half (x1)
top half: current assets (cash) increases ⬆️
bottom half: share capital increases ⬆️
how is a share price calculated?
- ‘Balance Sheet’
valuation - assets minus its liabilities - ‘multiplier’
valuation - avg profit multiplied by a factor relevant to the particular industry. - market capitalisation (listed companies) - number of shares in issue multiplied by share price at a given time.
The price of a share will comprise
nominal value + premium
although shares can trade at a discount to nominal value.
what is the effect of issuing a share for more than its nominal value on the balance
sheet?
top half (x1) + bottom half (x2):
top half: current assets (cash) increases ⬆️
bottom half:
- share capital increases ⬆️ (nominal value)
- share premium increases ⬆️ (excess above nominal value i.e., the premium)
what can share premium account funds be used for?
limited purposes
what is gearing or leverage?
liabilities : shareholder funds ratio
ie
debt : equity ratio
the higher the debt : equity ratio…
…the more highly geared a company is
what is the gearing formula?
long term debt (non-current liabilities) / equity (total equity) x 100%
ie
(long term debt / total equity) x 100%
example: high level of gearing (75%)
how are more highly geared companies seen by banks and other lenders?
risky
are lenders more or less likely to lend to highly geared companies?
less likely :(
why are lenders less likely to lend to highly geared companies?
- because the company has less equity to absorb any losses the company might make (less equity to protect creditors)
- highly geared companies will need to make more profits before interest and tax (PBIT) in order to meet the demands for interest payments. interests eats into profit but needs to paid to avoid the company being in default.
- company with a lot of debt is less likely to have
assets which can be secured in favour of any new lender(s) (as these will probably already have
been secured in respect of the existing debt) - may be difficult to issue security over the same asset
why is it more risky for lenders when a company is highly geared and therefore has less equity to absorb losses?
shareholders are paid last in the statutory order of priority on a winding up of a company, meaning that a company with a lot of equity can make substantial losses before it runs out of money to pay back its creditors
despite all the risks of being highly geared, why might a company choose to become highly geared anyway?
- leverage - by borrowing money, it can make a far bigger investment than a company could have made if it was just using its own resources (but note that higher gearing can also increase the scope for larger losses!!!)
- avoids dilution of shares and therefore may have no effect on shareholders’ ROI / improve earnings per share (profit)
