Chapter 37- gearing ratios

Question 1

What ratios included in gearing?

Answer 1

1. Gearing
2. Interest cover

Question 2

What is gearing concerned with?

Answer 2

• gearing concentrates on the long-term liabilities of the business and its ability to borrow money
• and its ability to cover the cost of borrowing

Question 3

Gearing

Answer 3

• this type of ratio considers the level of risk for a business
• it measures the level of risk by comparing the levels of debt and the amount of equity (capital employed) within the business
• gearing is the percentage of long-term finance that is made up from loans rather than shareholders’ funds and retained profits
• the gearing ratio is deemed to be high if the long term borrowing (non current liabilties) is more than 50% of the capital employed (total equity) and low if below 50%
• if the proportion of borrowing (debt) is high, there is more interest to pay and any fall in sales revenue and subsequently profit will make it harder for the business to finance this borrowing
• the higher the proportion of assets financed through long term borrowing the greater is the risk for the business
• if the business is highly geared (high proportion of debt) then a potential leader to the business is less likely to be willing to make further lending; business is at greater risk of not being able to meet the interest changes and therefore the risk may be too high
• banks are keen to know the level of gearing that already exists within a business before making any additional loans.
• if the business is already highly geared the bank will be less likely to lend the money
• if a high proportion of the capital within the business is borrowed the business owns less capital to use as security or any additional loan

Question 4

Gearing ratio formula

Answer 4

Gearing ratio is used to judge if a loan should be granted
Gearing ratio= non current liabilities/ capital employed x 100

Question 5

Debt to equity ratio

Answer 5

• this ratio compares the long term liabilities with the share capital and retained profits

Formula: debt/ equity x 100

Question 6

Benefits of having a low gearing ratio

Answer 6

• there are fewer funds that require repaying helping to keep costs down. This could be significant if interest rates are high
• it is easier to gain future borrowing from banks

Question 6

Benefits to being highly geared (having a high proportion of long term liabilties to shareholders funds and retained profits)

Answer 6

• it may be a cheaper alternative source of funds when level of interest rates and the level of profits
• if the gearing is high, perhaps there are fewer shareholders to be concerned about and therefore control of the company may be easier
• being highly geared may be deliberate; some companies have bought back shares when profits are high to reduce dividend payments

Question 7

Interest cover

Answer 7

• used to help decide if a business can afford to repay any loan
• this ratio measures the number of times in which a business can pay its interest charges with the operating profit it makes
• an answer of 3 means that there is sufficient profit generated to cover the cost of interest to be paid on a loan three times
• the higher the number the better as this indicates that the business can easily afford the interest payments

Formula
Operating profit/ interest payable (finance costs)