Financial Leverage & Risk Flashcards
What are some key ratios of Financial strength?
- Equity
- Equity ratio
- Debt-Equity ratio
(- Equity-to-personnel expenses)
What do we consider in terms of a firm’s long-term survival?
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
What is the formula for the equity ratio?
Equity ratio = Equity / Assets
What are the formulas for the debt-to-equity ratio?
All liabilities: Liabilities / Equity
Interest-bearing debt: Debt / Equity
What is the function of shareholders’ equity?
- Carry losses (long term fulfilment of obligation)
- Ability to lead the development in the industry
What does return on equity measure?
- 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
What profit measure do we use for ROE?
Net profit
What is the formula for Return on Equity?
ROE = Net profit / Equity
When is ROE = ROA?
When the firm is all equity financed (in a world without taxes)
What are the leverage formulas?
ROE = (1-t) * (ROA + (ROA-COL) * L/E)
ROE = (1-t) * (ROCE + (ROCE-COD) * D/E)
What is the spread/financial margin?
ROA-COL
Shows how much we pay vs how much it generates
What is the effective tax rate?
Not the official rate –> calculate from the income statement
Effective tax rate = Tax expense / Profit before taxes
What is COL?
Cost of total liabilities = Financial expenses / Total liabilities
What is COD?
Cost of debt = Financial expenses / (interest bearing) Debt
What is an inherent risk of borrowing to increase the owners’ returns?
That leverage also works the other way around in negative times
Is COD or COL closer to the real interest level?
COD
When should we use opening balances and when should we use closing balances?
- Opening: profitability/leverage, what we performed last year, backward looking
- Closing: Financial strength (liquidity, WC), forward looking
What are benefits of using the leverage ratio of ROCE instead of ROA?
- 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)
What are issues that makes the leverage formula with ROCE more difficult?
- 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.
What is business risk (in words)?
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)
What does a positive spread imply?
That the firm can borrow more
Should a firm with high business risk have much or little equity?
More equity, in case of losses
What part of the leverage formula shows total risk?
ROE
What part of the leverage formula shows business risk?
ROCE
