Financial Leverage & Risk

Question 1

What are some key ratios of Financial strength?

Answer 1

• Equity
• Equity ratio
• Debt-Equity ratio

(- Equity-to-personnel expenses)

Question 2

What do we consider in terms of a firm’s long-term survival?

Answer 2

How they are financed, Equity can be seen as a buffer for the future. Need to relate equity to something to be able to compare

Question 3

What is the formula for the equity ratio?

Answer 3

Equity ratio = Equity / Assets

Question 4

What are the formulas for the debt-to-equity ratio?

Answer 4

All liabilities: Liabilities / Equity

Interest-bearing debt: Debt / Equity

Question 5

What is the function of shareholders’ equity?

Answer 5

• Carry losses (long term fulfilment of obligation)
• Ability to lead the development in the industry

Question 6

What does return on equity measure?

Answer 6

• The profitability for the owners
• The capital measure = equity (what belongs to owners)
• Profit number represents what is left for owners after other stakeholders have been compensated = net profit

Question 7

What profit measure do we use for ROE?

Answer 7

Net profit

Question 8

What is the formula for Return on Equity?

Answer 8

ROE = Net profit / Equity

Question 9

When is ROE = ROA?

Answer 9

When the firm is all equity financed (in a world without taxes)

Question 10

What are the leverage formulas?

Answer 10

ROE = (1-t) * (ROA + (ROA-COL) * L/E)

ROE = (1-t) * (ROCE + (ROCE-COD) * D/E)

Question 11

What is the spread/financial margin?

Answer 11

ROA-COL

Shows how much we pay vs how much it generates

Question 12

What is the effective tax rate?

Answer 12

Not the official rate –> calculate from the income statement

Effective tax rate = Tax expense / Profit before taxes

Question 13

What is COL?

Answer 13

Cost of total liabilities = Financial expenses / Total liabilities

Question 14

What is COD?

Answer 14

Cost of debt = Financial expenses / (interest bearing) Debt

Question 15

What is an inherent risk of borrowing to increase the owners’ returns?

Answer 15

That leverage also works the other way around in negative times

Question 16

Is COD or COL closer to the real interest level?

Answer 16

COD

Question 17

When should we use opening balances and when should we use closing balances?

Answer 17

• Opening: profitability/leverage, what we performed last year, backward looking
• Closing: Financial strength (liquidity, WC), forward looking

Question 18

What are benefits of using the leverage ratio of ROCE instead of ROA?

Answer 18

• Restrictions on capital structure only concern financial liabilities (D/E)
• Division of responsibility and influence (better on area level)
• Comparability (D/E international measure of capital structure)

Question 19

What are issues that makes the leverage formula with ROCE more difficult?

Answer 19

• How to distinguish between operating liabilities and financial liabilities.
• Although it makes sense to classify some of the liabilities as operating, they may still seem hard to influence by people in the operation.
• The presence of large operating liabilities may make capital employed become so small that it may cease to be a useful capital basis from which to calculate a return.

Question 20

What is business risk (in words)?

Answer 20

Business risk: inherent in operations.
- Difficult to quantify
- One way to see is volatile profits = higher business risk

• Uncertainty about revenues/expenses (market situation, business idea and its quality, demand, input prices, suppliers)
• Ability to transfer costs to customers (competition, customers)
• Ability to adjust production facilities and resources, and employees (flexibility, variable vs fixed cost)

Question 21

What does a positive spread imply?

Answer 21

That the firm can borrow more

Question 22

Should a firm with high business risk have much or little equity?

Answer 22

More equity, in case of losses

Question 23

What part of the leverage formula shows total risk?

Answer 23

ROE

Question 24

What part of the leverage formula shows business risk?

Answer 24

ROCE

Question 25

What part of the leverage formula shows financial risk?

Answer 25

(ROCE - COD) * D/E

Question 26

What is financial risk (in words)?

Answer 26

Financial risk:
- Depends on how the company thinks of financing (possible to influence more)

Question 27

How do we adjust for appropriations and untaxed reserves when calculating the ROE?

Answer 27

Don’t want it to distort profits.
- Remove appropriations from income statement.
- Divide UR between Equity and Deferred tax liabilities in balance sheet. Use official tax rate (20% in this course)

Question 28

What is an alternative formula for the Interest Coverage Ratio?

Answer 28

ICR = (ROA / COL) * (A / L)