Understanding Business Accounting For Dummies, 2nd Edition (46 page)
Read Understanding Business Accounting For Dummies, 2nd Edition Online
Authors: Colin Barrow,John A. Tracy
Tags: #Finance, #Business
If you default on your debt contract - you don't pay the interest on time, or you don't pay back the debt on the due date - you face some major unpleasantries. In extreme cases, a lender can force you to shut down and liquidate your assets (that is, sell off everything you own for cash) to pay off the debt and unpaid interest. Just as you can lose your home if you don't pay your home mortgage, your business can be forced into involuntary bankruptcy if you don't pay your business debts.
Trading on the equity: Taking a chance on debt
The large majority of businesses borrow money to provide part of the total capital needed for their assets. The main reason for debt, by and large, is to close the gap between how much capital the owners can come up with and the amount the business needs. Lenders are willing to provide the capital because they have a senior claim on the assets of the business. Debt has to be paid back before the owners can get their money out of the business. The owners' equity provides the permanent base of capital and gives the lenders a cushion of protection.
The owners use their capital invested in the business as the basis to borrow. For example, for every two pounds the owners have in the business, lenders may be willing to add another pound (or even more). Thus, for every two pounds of owners' equity the business can get three pounds total capital to work with. Using owners' equity as the basis for borrowing is called
trading on the equity.
It is also referred to as
financial leverage,
because the equity is the lever for increasing the total capital of the business.These terms also refer to the potential gain a business can realise from making more EBIT (earnings before interest and tax) on the amount borrowed than the interest on the debt. For a simple example, assume that debt supplies one-third of the total capital of a business (and owners' equity two-thirds, of course), and the business's EBIT for the year just ended is a nice, round £3,000,000. Fair is fair, so you could argue that the lenders who put up one-third of the money should get one-third or £1,000,000 of the profit. This is not how it works. The lenders (investors) get only the interest amount on their loans (their investments). Suppose this total interest is £750,000. The financial leverage gain, therefore, is £250,000. The owners would get their two-thirds share of EBIT plus the £250,000 pre-tax financial leverage gain.
Trading on the equity may backfire. Instead of a gain, the business may realise a financial leverage loss - one-third of its EBIT may be
less
than the interest due on its debt. That interest has to be paid no matter what amount of EBIT the business earns. Suppose the business just breaks even, which means its EBIT equals zero for the year. Nevertheless, it must pay the interest on its debt. So, the business would have a bottom-line loss for the year.We haven't said much about the situation in which a business has a loss for the year, instead of a profit. A loss has the effect of decreasing the assets of a business (whereas a profit increases its assets). To keep it simple, assume cash is the only asset decreased by the loss (although other assets could also decrease as a result of the loss). Basically, cash goes down by the amount of the loss; and, on the other side of the balance sheet, the retained earnings account goes down the same amount. The owners do not have to invest additional money in the business to cover the loss. The impact on the owners is that their total equity (the recorded value of their ownership in the business) takes a hit equal to the amount of the loss.
A lender may allow the business to try to work out its financial crisis through bankruptcy procedures, but bankruptcy is a nasty business that invariably causes many problems and can really cripple a business.
Reporting Financial Condition: The Classified Balance Sheet
The assets, liabilities, and owners' equity of a business are reported in its
balance sheet,
which is prepared at the end of the profit and loss account period.
The balance sheet is not a flow statement but a
position
statement which reports the financial condition of a company at a precise moment in time - unlike the income and cash flow statements which report inflows and outflows. The balance sheet presents a company's assets, liabilities, and owners' equity that exist at the time the report is prepared.
An accountant can prepare a balance sheet at any time that a manager wants to know how things stand financially. However, balance sheets are usually prepared only at the end of each month, quarter, and year. A balance sheet is always prepared at the close of business on the last day of the profit period so that the financial effects of sales and expenses (reported in the profit and loss account) also appear in the assets, liabilities, and owners' equity sections of the balance sheet.
The balance sheet shown in Figure 6-1 is a bare-bones statement of financial condition. Yes, the basic assets, liabilities, and owners' equity accounts are presented but for both internal management reporting and for external reporting to investors and lenders, the balance sheet must be dressed up rather more than the one shown in Figure 6-1.
As another example, the balance sheet shown in Figure 6-1 includes just one total amount for debtors but managers need details on which customers owe money and whether any major amounts are past their due date. Therefore, the assets and liabilities of a business are reported to its managers in greater detail, which allows for better control, analysis, and decision-making. Management control is very detail-oriented: Internal balance sheets and their supporting schedules should provide all the detail that managers need to make good business decisions.
external
financial reports (which go out to investors and lenders) do not include much more detail than the balance sheet shown in Figure 6-1. However, external balance sheets must classify (or group together) short-term assets and liabilities. For this reason, external balance sheets are referred to as
classified
balance sheets.
This classification is not mandatory for internal reporting to managers, although separating short-term assets and liabilities is also useful for managers.
