Chapter 13 - capital structures and financial ratios Flashcards
what is financial gearing ?
Financial gearing measures the proportion of a companies finances that comes from debt as apposed to equity
what are the pros and cons of having debt rather than equity
Pros
Cheaper because;
1. Lenders are likely to require lower return than shareholders because investment in debt is less risky
- Debt interest payable by a company is normally allowable for tax which makes the net cost even lower
Cons
More risk to shareholders because fixed interest must be paid first before dividends
what is the gearing ratio ?
Debt borrowing + preference share capital / ordinary share capital + reserves
Or
Debt borrowing + preference share capital / total long term capital
Either measure can be used depends on how asked in exam
Market values are best used for debt and equity, but if not available SFP
what is operating gearing
Like with financial gearing where more fixed interest is more riskier the same is true with more fixed costs vs variable costs. The higher the fixed costs the more riskier so perhaps opt to hire people on day to day rather than fixed contracts for example. The formula is:
Contribution / operating profit
What do we mean by capital structure ?
Rather than just finance via equity or debt, capital structure looks at a blend of both
How does the profit % change if a company has more fixed costs (operating gearing) or interest rates (financial gearing)
If the company has higher fixed costs be it fixed costs vs variable costs or interest costs vs only equity then a falls in profits gives higher % change (worse) for the fixed costs but an increase in sales gives a higher % charge (good)
What is the interest cover ratio
Profit before interest and tax / interest
Tells us how easy it is for the business to be paying the business
What is the interest yield ratio
Interest / market value
What is the dividend per share ?
Dividend / total share
Only look at ordinary share
What is the dividend cover ratio ?
Earnings available to ordinary shareholders / dividend to the ordinary shareholders
Earning available = net profit after tax less and preference shares
This shows how many times can the dividend be paid
What is the dividend yield ratio
Only for ordinary shares holders
Dividend per share / market value per share
What is the earning per share ratio
Profit available for ordinary shareholders / number of shares
What is the dividend cover ratio
Earning per share ratio / dividend per share ratio
What is the price earning ratio (pe)
SUPER IMPORTANT!
Market value of ordinary share / earning per share
What’s the relevance?
If the ratio is 16 then it will take 16 years to get back the money back at current earnings, why on earth would you buy shares in the company ? The reason is, what determines to pay in the share is what you expect the share to perform in the company.
Therefore higher PE ratio the higher expected growth, one time Amazon had a PE ratio of 2,000
