The phrase trading on equity is a financial jargon which indicates the utilization of non-equity sources of funds in the capital structure of an enterprise. At a high debt-equity ratio, a firm may not be able to borrow funds at a cheaper rate of interest it may not able to borrow funds at all. This is so because creditors lose confidence in the company which has a high debt-equity ratio. How can creditors have confidence in the company which has only creditors and no equity stockholders? The company will, therefore, have to strive hard to regain a reasonable debt-equity ratio so that the expectations of the market may be satisfied. In fact, equity financing by way of a public sale of stock offers real value of a firm. Traditionally, it has served as a spearhead for expansion of resources and productive capacity involving risk. Merwin Waterman states that the term Continue reading
Financial Management Concepts
Appropriate Capital Structure
An Appropriate Capital Structure is that capital structure at that level of debt — equity proportion where the market value per share is maximum and the cost of capital is minimum. It is important for a company to have an appropriate capital structure. Features of an Appropriate Capital Structure Return- The capital structure of the company should be most advantageous subject to other considerations it should generate maximum returns to the shareholders without adding cost to them. Risk- The use of excessive debt threatens the solvency of the company. To the point debt does not add significant risk it should be used otherwise its use should be avoided. Flexibility- The capital structure should be possible for a company to adapt its capital structure with a minimum cost and delay if warranted by a changed situation. It should also be possible for the company to provide funds whenever needed to finance Continue reading
Capital Structure and Risk-Return Tradeoff
The capital structure of a firm should be designed in such a way that it keeps the total risk of the firm to the minimum level. The financial or capital structure decision of a firm to use a certain proportion of debt or otherwise in the capital mix involves two types of risks: Financial Risk: The financial risk arise on account of the use of debt or fixed interest bearing securities in its capital. A company with no debt financing has no financial risk. The extent of financial risk depends on the leverage of the firm’s capital structure. A firm using debt in it capital has to pay fixed interest charges and the lack of ability to pay fixed interest increases the risk of liquidation. The financial risk also implies the variability of earning available to equity shareholders. Non-Employment of Debt Capital (NEDC) Risk: If a firm does not use Continue reading
Difference Between Job Costing and Process Costing
The main objective of manufacturing firms is to make profit. The profit on each product sold is the difference between the selling price of the product and the total cost of making the product. Cost therefore plays an important role in the product design process. To calculate the cost that incurred on the product we use different Costing Techniques. Costing is not an easy task because in the process of manufacturing a product many indirect materials and labor are used. To identify these costs we use different costing techniques. Here we are going to discuss two methods of costing; Job Costing and Process Costing. Job Costing Job Costing is to calculate the costs involved of a business in manufacturing goods. These costs are recorded in ledger accounts throughout the year and are then shown in the final trial balance before the preparing of the manufacturing statement. In a job costing Continue reading
Financial Leverage and the Shareholders Risk
It has is seen that financial leverage magnifies the shareholder’s earnings. It has also been observed that the variability of EBIT causes EPS to fluctuate within wider ranges with debt in the capital structure. That is, with more debt, EPS rises and falls faster than the rise and fall of EBIT. Thus, financial leverage not only magnifies EPS but also increases its variability. The variability of EBIT and EPS distinguish between two types of risk- operating risk and financial risk. 1. Operating Risk- Operating risk can be defined as the variability of EBIT (or return on assets). The environment- internal and external- in which a firm operates determines the variability of EBIT. So long as the environment is given to the firm, operating risk is an unavoidable risk. A firm is better placed to face such risk if it can predict it with a fair degree of accuracy. The variability Continue reading
Economic Value Added (EVA) Vs. Return on Investment (ROI)
Most of the companies employing investment centers evaluate business units on the basis of Return on Investment (ROI) rather than Economic Value Added (EVA). There are three apparent benefits of an ROI measure. First, it is, a comprehensive measure in that anything that affects financial statements is reflected in this ratio. Second, Return on Investment (ROI) is simple to calculate, easy to understand, and meaningful in an absolute sense. For example, an ROI of less than 5 percent is considered low on an absolute scale, and an ROI of over 25 percent is considered high. Finally, it is a common denominator that may be applied to any organizational unit responsible for profitability, regardless of size or type of business. The performance of different units may be compared directly to one another. Also, ROI data are available for competitors and can be used as a basis for comparison. The collar amount Continue reading