1. While two companies can have identical profit and loss statements, there is nothing stating that their returns will be identical. The returns could be very similar, and even identical in very rare circumstances, but it is not guaranteed. The reason that they could have similar profit and loss statements is because they are in the same industry and sell a product that is very, very similar to their competitors. The differentiating factor determining the returns and profits and losses are the capital structures of the companies.
The capital structure “describes the mix of a firm’s long-term capital, which consists of a combination of debt and equity.” (Loth, 2020). Capital structure is a “permanent type of funding that supports a company’s growth and related assets.” (Loth, 2020). Capital structure is equal to the debt obligations in addition to their shareholders’ equity. There are three ratios that are used to assess the overall strength of a company’s capital structure. Those three formulas are the debt ratio, debt-to-equity ratio, and the capitalization ratio.
It is also important to note that the companies sources of financing may be different, and could contain more debt than equity and vice versa. If a company uses more of their debt than capital shares or equity, it increases the company’s financial liabilities. When the financial liability of a company increases, the financial risk increases, which makes the return higher. If the company has chosen to use capital shares for financial obligations, they may be required to liquidate some of their shares. Hence, the debt-equity ratio could be off which is why the amount of the returns varies. In this case, the company that is required to liquidate their shares would be riskier since their financial risk is higher than that of their competitor.
2. Two companies may have the same profitability shown in the P& L statement or Income Statement. However, the annual returns to their investors, in the form of dividends, often, are quite different. How will this happen? We need to look at the capital structure of the company, in other words, we need to look at what comprises of the assets of the company. Normally, a company’s assets is composed of three parts, the first part is the own assets of the company, the liquidity. The second part is the debts in the form of bonds or loans, both long-term and short-term, for which the company needs to pay interests. The third part is the equity, in the form of stocks for which the company will pay dividends. With these three parts of the assets working together, the company conducts business and earns a profit or loss—net income or net loss.
The mixture of the three parts of the asset is very important to the health of the operations of the company, especially the ratio of debt and equity. According to Tuovila (2020), there is a high leverage mixture, such as 50% liquidity (asset), 40% debts and 10% equity and there is a low leverage mixture, such as 50% liquidity (asset), 10% debts and 40% equity. The assets with a higher percentage of equity is riskier, even if it may bring in greater prospects for profits.
The dividend per share formula is as follows: (Net Income – Dividends on Preferred Stock)/the Number of Outstanding Stocks). With a different capital structure, the two companies with the same profitability may have different mixture of equity, and therefore may have different dividends each year and different number of outstanding stocks. So even if the Net Income is the same, the dividends per share of stock will be different.
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