6 Why are preference shares normally treated as debt when calculating the gearing ratio? A Preference shares affect the volatility suffered by ordinary shareholders. B Preference shares can sometimes be classified as debt in the financial statements. C Preference dividends can be suspended. D Preference shares can be redeemable. May I know why the answer for this is A since D is also acceptable ? 7 Which of the following best explains why investment analysts often use earnings before interest, tax, depreciation and amortisation (EBITDA) as a performance measure? A EBITDA is a more objective measure than profit for the year. B EBITDA is a more realistic measure of overall performance than profit for the year. C EBITDA is likely to be greater than profit for the year. D EBITDA is likely to be smaller than profit for the year. May I know why the answer for this is A since B is also acceptable ?
For your first Q, the answer is A because at the time of liquidation of the company, the preference shareholders will be given priority over ordinary shareholders for their money repayment. So this increases the risk exposed to the ordinary shareholders, and hence more volatility for them. Thus preference shares are treated as debt of the company. For your second Q, EBITDA is used because it is the amount before all expenses. After tax, depreciation and amortization, the profits may reduce down to losses, but that does not mean that the company is performing badly. Depreciation and amortization are non-cash expenses, where there is no outflow of cash. But still they lower the net profit. So it is better to use EBITDA instead of net profits. Coming to interest, different companies may be giving interest on different rates. So it will not provide a uniform basis for comparison of two companies on the earnings after interest. Also, taxes may vary from industry to industry, or w.r.t. income level (not for companies though). So ay an objective level, if you are comparing two companies, then their EBITDA will give you a better idea of how the company is working. I hope this answers your doubt. All the best!
