Understanding the Role of Preference Shares in Debt to Equity Ratio: An Accounting Tutorial
When diving into the world of corporate finance, students often encounter a variety of ratios designed to assess the financial health and performance of a company. One of the key ratios in this area is the debt to equity ratio, which measures the financial leverage of a company by comparing its total liabilities to shareholders’ equity. In this tutorial, we will answer the critical question: Is preference share included in debt to equity ratio? We will also explore in detail what this ratio represents, how to calculate it, and how preference shares impact the calculation.
Let’s break down the concepts step-by-step, using examples and journal entries to ensure a clear understanding.
What is the Debt to Equity Ratio?
The debt to equity ratio is a financial leverage ratio that compares the total debt of a company to its total equity. This ratio is used to evaluate the financial risk of a business and the proportion of funding that comes from debt versus equity.
The formula to calculate the debt to equity ratio is:
Debt to Equity Ratio=Total DebtTotal Equity\text{Debt to Equity Ratio} = \frac{\text{Total Debt}}{\text{Total Equity}}
- Total Debt: Includes both short-term and long-term borrowings, such as loans, bonds, or other forms of borrowing.
- Total Equity: Refers to the shareholders’ equity, which includes common stock, retained earnings, and any other equity investments.
What Are Preference Shares?
Preference shares (also known as preferred stock) are a type of equity instrument. These shares give holders a preferential claim on the company’s assets and earnings before common shareholders. This means preference shareholders have a priority in receiving dividends and in case of liquidation, though they do not have voting rights in most cases.
However, despite being classified as equity, preference shares can resemble debt in some ways, especially because they offer fixed dividends, similar to the interest payments on bonds or loans. This raises the question: Should preference shares be included in the debt to equity ratio?
Are Preference Shares Included in the Debt to Equity Ratio?
To answer this question, it is essential to understand that the debt to equity ratio measures the risk associated with financial leverage. While preference shares are technically equity, their treatment in the debt to equity ratio depends on their characteristics:
- Fixed Dividend Payment: Preference shares typically come with a fixed dividend, much like an interest payment on debt.
- Preference in Liquidation: Preference shareholders have a priority claim on the company’s assets during liquidation, which also resembles the seniority of debt holders.
Accounting for Preference Shares
The accounting treatment for preference shares depends on whether they are classified as equity or liability in the financial statements. Preference shares are generally classified as equity if they do not have a fixed redemption date and are not mandatorily redeemable. However, if the company is required to redeem the shares, or if they have debt-like features, they may be classified as liabilities.
For the purpose of the debt to equity ratio, preference shares are typically excluded from debt in most financial analyses. However, in some cases, companies may choose to include them as part of their debt due to their fixed financial obligations (the dividend). The treatment may vary based on specific accounting standards, such as IFRS or GAAP.
Let’s explore this concept with examples and journal entries.
Example 1: Issuing Preference Shares (Equity)
Let’s assume that a company, ABC Ltd., issues 1,000 preference shares at $100 each. The total value of the preference shares is $100,000. Since these shares have no mandatory redemption and are classified as equity, they will not be included in the debt to equity ratio.
Journal Entry for Issuance of Preference Shares (Equity)
In this case, the preference shares are classified as equity, so they are part of the equity section of the balance sheet but not considered debt.
Example 2: Issuing Preference Shares (Liability)
Now, let’s assume ABC Ltd. issues 1,000 preference shares, but these shares come with a mandatory redemption after 5 years. This creates a liability for the company, and these shares will be treated as debt rather than equity.
Journal Entry for Issuance of Preference Shares (Liability)
In this case, the preference shares will be classified as debt on the balance sheet, meaning they will be included in the total debt when calculating the debt to equity ratio.
Example 3: Calculating Debt to Equity Ratio with Preference Shares
Let’s now calculate the debt to equity ratio for ABC Ltd. using both of the scenarios above.
Scenario 1: Preference Shares as Equity
Assume ABC Ltd. has the following financial data:
- Total Debt: $500,000 (consisting of loans and bonds)
- Total Equity: $1,000,000 (including common shares and retained earnings)
- Preference Shares (Equity): $100,000
In this case, the debt to equity ratio is calculated as:
Scenario 2: Preference Shares as Debt
Now, assume the preference shares are classified as debt. In this case, the calculation would change as follows:
- Total Debt: $500,000 (loans and bonds) + $100,000 (preference shares classified as debt) = $600,000
- Total Equity: $1,000,000
The debt to equity ratio would then be:
As you can see, the treatment of preference shares affects the debt to equity ratio. In Scenario 1, the ratio is 0.45, but in Scenario 2, it increases to 0.60 due to the inclusion of the preference shares as debt.
Financial Statements Impact
Let’s examine the impact on ABC Ltd.’s balance sheet in both scenarios.
Balance Sheet – Preference Shares as Equity
Balance Sheet – Preference Shares as Debt
Practice Questions
Now that we have explored the key concepts, let’s test your understanding with a few practice questions.
Question 1:
Company XYZ issued 500 preference shares at $200 each. These shares are non-redeemable and do not have any fixed redemption date. The company has the following financial data:
- Total Debt: $400,000
- Total Equity: $600,000
- Preference Shares: $100,000
Calculate the debt to equity ratio and explain how preference shares are treated in the ratio.
Answer:
Since the preference shares are non-redeemable and do not have debt-like characteristics, they will be treated as equity.
Question 2:
Company ABC issued 1,000 preference shares at $100 each. These shares are mandatorily redeemable in 5 years. The company has the following financial data:
- Total Debt: $800,000
- Total Equity: $1,200,000
- Preference Shares: $100,000
How would the preference shares affect the debt to equity ratio?
Answer:
Since the preference shares are mandatorily redeemable, they will be treated as debt.
Question 3:
Company LMN issued 2,000 preference shares at $50 each. These shares are non-redeemable, but the company has the option to redeem them at a later date. The company has the following financial data:
- Total Debt: $1,000,000
- Total Equity: $2,000,000
- Preference Shares: $100,000
How would the preference shares affect the debt to equity ratio?
Answer:
Since the preference shares are non-redeemable and have no mandatory redemption, they will be treated as equity.
Conclusion
In conclusion, preference shares can either be treated as equity or debt depending on their specific characteristics. In most cases, preference shares that do not have debt-like features (such as mandatory redemption) are included in the equity portion of the debt to equity ratio. However, if preference shares are mandatorily redeemable or carry debt-like obligations, they may be classified as debt. This distinction plays a crucial role in financial analysis, as it can significantly impact a company’s debt to equity ratio and, by extension, its financial risk profile.
Understanding how preference shares are treated in financial statements and ratios is an essential part of corporate finance, and the ability to make these distinctions will aid in effective financial decision-making.
