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Course: Finance and capital markets > Unit 6
Lesson 3: Understanding company statements and capital structureBasic capital structure differences
Understanding basic capital structure differences. Created by Sal Khan.
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We can see that interest expense is taken out of the operating profit before being taxed, and consequently Jason pays less tax on his operating profit than Ben does, because it is lower.
My question is, is it possible to lend money to yourself, (Say through a company) so that you can pay interest expense to yourself, (thereby not losing any money) and at the same time pay less taxes because the interest expense is taken out before tax?
sorry if the question is weirdly phrased, I can't think of a clearer way to say it.(7 votes)
No, because you would have interest income equal to your interest expense.(6 votes)
- Why Net Income is not part of a company's Assets?(2 votes)
- Because income is, by definition, not an asset.
As net income is earned, it is transferred to the balance sheet as equity.
The cash that came in as you were earning the income becomes an asset on the other side of the balance sheet, and if you buy something with it that also becomes an asset(7 votes)
Suppose a business owns rather than rents the building or property which they run their business out of. Would that real estate be considered an asset? If so, how would it be categorized?(3 votes)- Of course it is an asset. It would be considered part of a category that is often called PP&E for Property, Plant, & Equipment.(5 votes)
what happens when there are more liabilities than assets?(3 votes)
Yes, something definitely does happen. If liabilities exceed assets, then there is no equity. The company's shares would have a book value of zero (or negative), and there is risk of the company defaulting on debt obligations. It would be an indicator that the company might want to undergo bankruptcy. See Khan's videos on bankruptcy - with the one on Chapter 11 bankruptcy being especially relevant. Chapter 11 would be likely to apply here, because the shoe store is bringing in money, and it probably makes sense to keep it open selling shoes, if it can only restructure its debt in bankruptcy court.
Note that banks or creditors might continue to lend (or restructure debt) to a company even though it has no equity. If creditors can be convinced that things will turn around, then normal operations might continue without liquidating assets, and bankruptcy could be avoided.(6 votes)
This is a general concepts question, not a question about a particular point in the video: Proponents of free-market capitalism maintain that when businesses are left alone to succeed, everyone benefits. Does it benefit society when a greater portion of a business's assets are equity; doesn't that lead to more income for a greater number of people via shares? Thank you.(2 votes)- It really doesn't make a difference. All of the income of a business goes either to debt holders in the form of interest or equity holders in the form of dividends or retained earnings. Both groups are people. Some people prefer the certainty of interest over the uncertainty of equity income. Others like the greater potential for bigger gains with equity income.(3 votes)
For inventory is that the revenue of the shoes or is that the gross profits (revenue-costs)? Also do you have to re-value your inventory constantly to the current prices?(2 votes)
Can anyone clarify more specifically Sal's statement: Capital Structure (CS) is about how the Assets are financed ? Is CS simply a firm's Liabilities or the Liabilities-Equity ratio ?(2 votes)- Hello, Why isn't the net income integrated into the owner's equity or added into asset as cash/revenue?
Thanks!(2 votes) - At3:10, Sal draws the equity in the Liability column, but is equity really a liability?(1 vote)
A= L + E (I always remembered this as Ale) is basically a fundamental accounting convention. But equity can be viewed as a liability as It's money due to the owners in a sense. I'll give you an absurd example to illustrate the point: Say real estate in Michigan all of a sudden went through the roof, and everyone was buying Teslas. The shareholders of GM could all band together and vote to liquidate the company. All the assets would be sold, and after paying off all the other senior liabilities (bonds and other debt), the rest is owed to the shareholders. The reason this doesn't happen too often is it's usually easier to sell the shares to someone else, or the shareholders hope to make more money by having the business run as a going concern. But it's quite a frequent occurence in small businesses. Might help to think of a home and mortgage as well.(2 votes)
- Can you please explain what is EPS mean in the balance sheet ?(1 vote)
- earnings per share. It's on the income statement, not the balance sheet.(1 vote)
3:10Video transcript
In the last video I talk about how both Ben's Shoes and Jason' shoes are fundamentally the same business but they have different capital structures. And the way we saw that is that, their everything, their revenue, gross profit all the way down to their operating profit was exactly the same. They are generating the same economics from the operating part of their business. But because they have different capital structures what happens below that line was a little different. In particular, you saw interest expense on Jason's business and not on Ben's income statement. So let's look at what that means. So if you look at both of these guys' assets so this down here, this is kind of their balance sheet. You see that they are the same they both have 20 thousand dollars in cash, and I've drawn it over here this is Ben's assets, 20 thousand dollars in cash, 20 thousand dollars in cash. They both have one hundred thousand dollars in inventory and I've made the height proportional to how many dollars we're talking about so they both have a larger amount of inventory, and then they both have 20 thousand dollars let me do that in that same color and they both have 20 thousand dollars of equipment so their assets are the same the things that are actually generating the revenue and the profit are the exact same thing we're assuming that they are also renting in very similar locations that's what would have to happen for them to have such similar economics. Now what's different about them is what happens on the other side of the balance sheet and this is what I meant by them having different capital structures so let me draw the liability's side for both of these characters so let's do liabilities liabilities there and liabilities over here now, they both have the same amount of accounts payables maybe the people they are buying shoes from are able to delay paying those shoes just a little bit so by a few months, or a few weeks, or whatever so they owe those vendors some money so they both have 5 thousand dollars in accounts payables let me do that in pink So they both have 5 thousand dollars. I will try to do proportional to the size so that right over there, that is the accounts payable the five thousand dollars. they both have that on the liability size now where they really diverge so this is the same amount 5 thousand dollars it should be about 1/4 of the size its not exactly how I've drawn it but where they really diverge is that Jason Jason over here let me do this in an appropriate colour Jason over here has 100,000 dollars in debt and Ben has no debt so in his liabilities he also has 100,000 dollars in debt this is the debt right over here, 100,000 dollars and Ben doesn't have it so the way you can think about capital structures they have the same assets, capital structures tells you how did they pay for their assets did they take it with debt are they deferring payments to some of their vendors or do they have equity and you can see whatever is left over remember owners equity is assets minus liabilities so what we have left over here is the owners equity so they both have 135,000 dollars in assets, you subtract 105,000 dollars in liabilities for Jason he has 35,000 dollars in owners equity On Ben's side he has much more so he kind of pays more of this or more of the capital structure equity here, more of it is debt 140,000 dollars in assets you have 5000 dollar liability here he has 135,000 dollars in equity so when we talk about capital structure we're saying how are we funding the assets and not only do we talk about the composition between debt and equity we also talking about the equity is composed and we can see in both of these their equity is split into 10,000 shares so each of those shares would be 1/10,000 of just the equity piece so you can split that into 10,000 or you can split this right here into 10,000