All trial balances and income statements include a plethora of accounts. Irrefragably, all these accounts seem to be important; nonetheless, Debt and Equity possess special characteristics. To understand their importance, recall the U.S. banking crises during 2008. Their stock values reached a zenith, but finally, a noticeable number of banking institutions failed and were insolvent. This happened because the U.S. banking institutions did not have enough equity to minimize or remove financial complexities. To perorate, equity and debt determine the financial strength and riskiness of every entity. Hence, every entity should determine, if it supports profit maximization or risk minimization.
The Debt?s Effect on Earnings per Share (EPS) and Return on Equity (ROE)
It is assumed that the use of debt improves the firm?s financial performance ratios, such as, Earnings per Share (EPS) and Return on Equity (ROE). It is also known that:
Net earnings = Earnings before Interest and Taxes (EBIT) ? Interest Expenses ? Taxes.
Further, it is indicated that the basic equation of any firm?s financial condition subjects itself to the here below stated formula, named as Basic Equation:
Assets = Liabilities (Debt) + (Equity +Net Earnings) (Mao, 1969; Solomon & Pringle, 1977).
Notably, net earnings represent an entity?s, year to-date, profits or losses (Porter & Norton, 2008). Additionally, the ratio of Equity over Total Assets is known as Financial LeverageRatio (Mao, 1969; Solomon & Pringle, 1977; Van Horne & Wachowicz, 2008).
To better understand the interrelationship among Equity, Debt, EBIT, Interest Expenses, Tax Rate, EPS, and ROE, the Table 1 presents a numeric example of company A. The financial data for the company A have as follows: (a) the assets have a value of $1,000, (b) the earnings before interest and taxes (EBIT) are equal to $250, (c) the tax rate is 50%, (d) the interest rate is 15%, (e) the stock price is $20 per share, and (f) there are 5,000 ($100,000 / $20) outstanding shares.
The columns 1, 2, and 3 in the Table 1 present various results according to three different conditions: (a) the column 1, shows the firm has a $1,000 equity and $0 debt; (b) the column 2, shows the firm has a $600 equity and a $400 debt; and (c) the column 3, shows the firm has a $400 equity and a $600 debt.
The Interrelationship among Equity, Debt, EBIT, EPS, ROE, Interest, and Taxes
Equity 100% = $1,000
Debts = $0 Equity 60% = $600
Debt = $400 Equity 40% = $400
Debt = $600
Elements (1) (2) (3)
Assets $1,000 $1,000 $1,000
Equity $1,000 $600 $400
Debt 0 $400 $600
EBIT $250 $250 $250
Interest 15% 0 $60 $90
Gross Income $250 $90 $160
Tax 50% $125 $95 $80
Net Income $125 $95 $80
Equity $1,000 $600 $400
No. of Shares 50 30 20
EPS $2.50 $3.167 $4.00
ROE 12.50% 15.83% 20.00%
1. Please, state your thoughts in reference to the use and effect of debt.
2. Should a firm utilize debt or not?
3. If your answer is yes, what do you thing the maximum level of debt should be? And
4. If your answer is no, why do you support this assumption?