Debt vs Equity in Accounting

Debt vs Equity – Borrow to Profit

It is important for a business to maintain the correct level of debt vs equity. The ability of a business to take on debt is limited by it’s ability to pay the interest charges and make the repayments.

However, debt should not be considered a bad thing, if used correctly if can greatly improve the return on equity earned by the owners of the business.

No Debt

To explain this point lets look at an example. Consider a business which has no debt making a 10% return on capital employed of 100,000.

Debt vs Equity: No debt
No Debt
Equity 100,000
Loans
Capital employed 100,000
Operating income 10,000
Interest
Income before tax 10,000
Return on Equity 10%
Debt to Equity ratio

Ignoring tax, the return on capital employed and the return on equity are the same at 10%, as there is no debt and all the capital employed is equity.

Return on capital employed = Income before tax / Capital employed
Return on capital employed = 10,000 / 100,000 = 10%
Return on equity = Income before tax / Equity
Return on equity = 10,000 / 100,000 = 10%

Normal 1:1 Debt vs Equity

Now consider what happens when debt is introduced at an interest rate of 4%. The return on capital employed is held at 10% but the total capital employed of 100,000 are split equally between debt and equity. The debt equity ratio is 1:1, which is a fairly normal ‘gearing‘ situation.

Debt vs Equity: 1:1
No Debt 1:1 Debt
Return on capital employed 10% 10%
Interest rate on debt 4% 4%
Equity 100,000 50,000
Debt 50,000
Capital employed 100,000 100,000
Operating income 10,000 10,000
Interest 2,000
Income before tax 10,000 8,000
Return on Equity 10% 16%
Debt to Equity ratio 1

The return on capital employed is still 10%. The business has paid interest at 4% on the debt amounting to 2,000, which leaves a profit for the equity shareholders of 8,000. The return on equity is now given as follows.

Return on equity = Income before tax / Equity
Return on equity = 8,000 / 50,000 = 16%

The effect of the gearing has been to increase the return on equity by 6% from 10% to 16%. The 6% difference is the difference between the return on capital employed and the interest rate = 10% – 4% = 6%. The business has borrowed at 4% and made a 10% return and has therefore earned an additional 6% on the borrowed funds.

High Debt vs Equity

In the next example the debt is increased even further. The debt equity ratio is increased to 3, and the business is considered highly geared.

Debt vs Equity: High Debt
No Debt 1:1 Debt High Debt
Return on capital employed 10% 10% 10%
Interest rate on debt 4% 4% 4%
Equity 100,000 50,000 25,000
Debt 50,000 75,000
Capital employed 100,000 100,000 100,000
Operating income 10,000 10,000 10,000
Interest 2,000 3,000
Income before tax 10,000 8,000 7,000
Return on Equity 10% 16% 28%
Debt to Equity ratio 1 3

Again, the return on capital employed is still 10%. The business has paid interest at 4% on the debt amounting to 3,000 which leaves a profit for the equity shareholders of 7,000. The return on equity is now given by

Return on equity = Income before tax / Equity
Return on equity = 7,000 / 25,000 = 28%

The effect of the gearing is to increase the return on equity by 18% from 10% to 28%. The 18% difference is the difference between the return on capital employed and the interest rate = 10% – 4% = 6% multiplied by the debt / equity ratio of 3 = 18%

The business has borrowed at 4% and made a 10% return and has therefore earned an additional 6% on the borrowed funds. Since the borrowed funds are 3 times the equity the total increase to the return on equity is 3 x 6% = 18%.

Relationship between Return on Equity and Return on Capital

More generally the relationship between the return on capital and the return on equity is as follows.

Return on equity = Return on capital + (Return on capital – Interest rate) x Debt vs Equity ratio

In the above example,

Return on equity = Return on capital + (Return on capital - Interest rate) x Debt vs Equity ratio
Return on equity = 10% + (10% - 4%) x 3 = 28%

So the higher the debt vs equity ratio the higher the return on equity.

Danger of High Debt vs Equity

There is however a problem with high debt vs equity. It makes a business more risky and vulnerable to a changing economic climate.

Consider what happens if the interest rate rises above the return on capital employed from 4% to 12%. Using the highly geared situation as an example.

Debt vs Equity: High Interest Rate
No debt High interest
Return on capital employed 10% 10%
Interest rate on debt 12%
Equity 100,000 25,000
Debt 75,000
Capital employed 100,000 100,000
Operating income 10,000 10,000
Interest 9,000
Income before tax 10,000 1,000
Return on Equity 10% 4%
Debt to Equity ratio 3

In this situation, the business has paid interest at 12% amounting to 9,000 leaving a profit for the equity holders of only 1,000. The return on equity is now given by as follows.

Return on equity = Income before tax / Equity
Return on equity = 1,000 / 25,000 = 4%

The return on equity has fallen from 10% to 4% a reduction of 6%. The 6% reduction is caused by the difference between the return on capital employed and the interest rate 10% – 12% = -2% multiplied by the debt equity ratio of 3 equals 6%. In this situation, the business has borrowed at 12% and made a return of 10% meaning that it loses 2% on it’s borrowing.

Using the formula above the return on equity is calculated as follows.

Return on equity = Return on capital + (Return on capital - Interest rate) x Debt / Equity ratio
Return on equity = 10% + (10% - 12%) x 3 = 4%

Useful tips when Considering Debt vs Equity

  • A business should only borrow if the amount it can earn on the capital employed in the business, is greater than the interest rate it has to pay on the debt.
  • In the good times when returns are high and interest rates are low, high debt vs equity amplifies the return on equity.
  • When the economy turns downwards, and the returns are low and interest rates are high, then high debt vs equity rapidly decreases the return on equity.
  • A business with high debt vs equity is more risky than a business with low debt vs equity.
  • Issuing of equity involves the owners of the business giving up part of their ownership and control. The use of debt finance avoids this complication.
  • Interest on debt finance is tax deductible in contrast to dividends which are not.
Debt vs Equity in Accounting September 20th, 2017Team

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