9 Capital Structure

Question 1

2 main sources of financing

Answer 1

1. Debt financing (loans from banks, acc payable, issue of bonds)
2. Equity financing (owners contribution, retained earnings)

Question 2

Debt-to-equity ratio formula

Answer 2

Total liabilities / shareholders’ equity

Proportion of debt used to finance company’s assets

Higher ratio - higher credit rating - better ability to repay borrowings

Question 3

Times interest earned ratio formula

Answer 3

(NI + Interest Expense + Tax Expense) / Interest Expense

Number of times net income can cover interest expense

Higher better

Question 4

Return on Assets (ROA)
Return on Equity (ROE)
ratio formulas

Answer 4

ROA = Net income / avg total assets

Profitability relative to total assets
Higher better

ROE = Net income / avg shareholder’s equity

Profitability relative to shareholders’ equity
Higher better

Question 5

3 main sources of debt financing

Answer 5

1. Trade payables (ord course of biz)
2. Issue of bonds
3. LT / ST payables

Question 6

Security deposit journal entry

• Amts received as a guarantee against an act they are expected to do/ not to do in future

Answer 6

Dr Cash (will be refunded once fulfil obligation - liability)
Cr Security deposit refundable

When refund is made:
Dr Security deposit refundable
Cr Cash

Question 7

What is a provision? Journal entry?

Answer 7

Liability of uncertain timing or amount

Has present obligation due to past events
-Probable (>50% possibility) outflow of resource
-Reliable estimates

Dr Warranty expense
Cr Provision for warranty

When cost is incurred
Dr Provision for warranty
Cr Cash

Question 8

What is a contingent liability

Answer 8

Possible (to 50% possibility) obligation which will be known upon outcome of uncertain future event

Never recognized - cannot be measured reliably - does not fulfil criteria for recognition

0% - remote
to 50% - possible
> 50% - probable
100% - virtually certain

Question 9

What are bonds?

Answer 9

Financial liabilities, long-term borrowing

Issuer commits to pay interest + repayment of principal

Question 10

Bond terminology

Answer 10

Discount - coupon interest < market interest rate

Premium - coupon interest rate > market interest rate

Question 11

Interest expense for bond formula

Answer 11

Interest expense = effective interest rate x bond carrying amt