11.9 Financial gearing

Question 1

What is financial gearing?

Answer 1

A measurement of the proportion of debt a company has relative to its equity. - it shows the extent to which a company is funded by lenders vs shareholders.

Question 2

Which is usually cheaper, debt or equity?

Answer 2

Debt, as it is tax deductible, and since it is less risky, lenders require lower rates of return than shareholders.

Question 3

How is financial gearing calculated?

Answer 3

Gearing = (debt borrowing + preference share capital) / (total long term capital)

Question 4

What is interest gearing?

Answer 4

A measure of the percentage of profit absorbed by interest payments or borrowings.

Question 5

How is interest gearing calculated?

Answer 5

Interest gearing = (debt interest + preference dividends) / (operating profits before debt interest and tax).

Question 6

What is the interest cover ratio?

Answer 6

An indication of how many times greater profit before interest and tax (PBIT) is than annual interest payments. i.e. how many times can interest be paid out of annual profits?

Question 7

How is interest cover ratio calculated?

Answer 7

Interest cover ratio = profit before interest and tax (PBIT) / annual interest payment

Question 8

Give reasons why high levels of gearing may be problematic.

Answer 8

• increased bankruptcy risk
• loan conditions constrain management’s options
• high debts levels can exhaust tax liability against which to offset interest
• running out of assets against which to secure loans
• increased cost of borrowing