In this session, we shall look at two financial position ratios, Interest Cover and Gearing. Both of these are a measure of a business’ financial risk.
Financial Risk
Financial risk is the risk that a business will not be able to service its debts or repay them. Most companies are financed using a mixture of equity and debt but the use of debt has particular problems associated with it.
- Debts must still be repaid even when the company’s performance has been poor or when it has little cash. This is different from equity, as a company can choose not to pay dividends to its shareholders during difficult times
- When a company has a relatively high level of debt, raising additional debt can become very expensive or it can even become impossible for the company to obtain more debt
Interest Cover
Interest cover looks at a business’ ability to service its debts. By service we mean whether or not the business is making enough profit to cover the interest costs on the debt. It does not however, refer to a company’s ability to make its loan repayments as this is dependent on the company’s cash or bank balances.
The formula used to calculate Interest Cover is shown below. The ratio is presented as a number of times (e.g. 4.6 times).
[Note that if a loss before finance costs is made, interest cover can still be calculated but a negative number will be calculated.]
Quick questions
1. A business’ profits before finance costs are £51,882 and its finance costs are £6,405. Calculate its interest cover to two decimal places
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Interest cover is 51,882/6,405 = 8.10 times
2. A business’ interest cover is 7.2 times. If its finance costs are £35,000 calculate its profit before finance costs
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Profit before finance costs are 35,000 x 7.2 = £252,000
Illustration
A company’s financial statements are shown below.
Both elements of the Interest Cover ratio can be found in a company’s Statement of Profit or Loss. In the above example, the profit before finance costs is the Profit from Operations.
Interest Cover: 1,750/600 = 2.92 times
Evaluating Interest Cover
A high or rising Interest Cover ratio is generally considered to be good as it indicates that the company can easily service its debts from the profit it makes. In addition, it indicates that the company should be able to raise additional debt funding if it is required.
A low interest cover (e.g. below 2 times) is a concern as it means that the majority of any profits being made are benefitting the business’ lenders more than its owners. Furthermore, if the business’ profits fall by a small amount the business might then start making losses.
Interest Cover: reasons for change
Interest cover will be affected by any changes to the company’s sales as well as its costs of sales and overheads. It will also be affected by changes to the company’s debt, for example if loans are taken out or repaid, or changes to the interest rates being charged on the company’s loans.
Gearing
Gearing is a measure of the mix of equity and debt that has been used to fund a business. As mentioned previously, debt is a popular way to fund a business but at high levels can be financially risky since it must be repaid irrespective of how the business is performing and can also become expensive or difficult to obtain.
There are a number of different Gearing ratios that are commonly used. This course however, will only consider the following (which should be presented as a percentage).
Quick questions
1. A business has borrowings of £52.8m and equity of £71.4m. Calculate to two decimal places the business’ gearing
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Gearing is 52.8/(52.8+71.4) x 100 = 42.51%
2. A business’ gearing is 40% and it has debentures of £650,000 in issue. Calculate the value of the business’ equity
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- Gearing = Debt/(Debt + Equity)
- If this is rearranged
- Debt + Equity = Debt/Gearing
- Debt + Equity = 650,000/40% = 1,625,000
- Equity is therefore 1,625,000 – 650,000 = £975,000
Illustration
We shall use the same example as shown above.
The company’s Gearing will be calculated using the Debt and Equity taken from the Statement of Financial Position. Debt is represented by the debentures included in Non-Current Liabilities.
Gearing: 6,500/(6,500 + 7,740) x 100 = 45.65%
Evaluating Gearing
The higher the level of gearing, the greater the financial risk. Whilst this statement may give the impression that company should avoid any debt, low levels of gearing (for example, 20%) are not generally regarded as a problem. In addition, low levels of gearing indicate that additional debt funding could be obtained by the business without causing any particular problems.
High levels of gearing, which for the ratio formula used, would be in the region of 50% and above is considered financially risky, as the company might struggle to repay its debts if the business’ performance worsens.
Gearing: reasons for change
In order to explain why a company’s gearing might be different or have changed we would simply look at what has happened to its equity and its debt.
Equity will change if the company has issued shares or bought them back. It will also change as profits or losses are made and dividends are paid and also if the company has revalued its assets in the period.
Debt will change as new loans are taken out or repaid. As debt often changes as a company purchases or sells non-current assets we should also consider how these have changed in the year as well.
Quick questions
1. A business has issued shares at their nominal value to its shareholders. What is the likely effect that this will have on the business’ gearing?
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An issue of shares will increase the value of the business’ equity. It will therefore reduce, or improve, the business’ gearing
2. A business’ gearing is 30%. The business decides to purchase new equipment costing £600,000 and will fund this purchase by issuing shares for £300,000 and taking out a bank loan for balance.
Will the business’ gearing rise or fall?
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This question can be tackled by imagining a business with, total debt of, say £600,000 and equity of £1,400,000. Its gearing is therefore 600,000/(600,000 + 1,400,000) x 100; i.e. 30%. By purchasing the equipment, its debt and equity will increase by £300,000 to £900,000 and £1,700,000 respectively. Its new gearing will be as follows:
900,000/(900,000+1,700,000) x 100 = 34.6%
The business’ gearing will therefore rise
Question 1
A business’ statement of profit or loss and statement of financial position are shown below.
a) Calculate, to one decimal place the business’ interest cover for both years. State whether the ratio has improved or worsened from 2019 to 2020
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- Y/E 31/12/2020 Interest cover: 83,612/8,770 = 9.5 times
- Y/E 31/12/2019 Interest cover: 79,930/11,360 = 7.0 times
- The interest cover has improved
b) Calculate, to one decimal place, the business’ gearing for both years. State whether the ratio has improved or worsened from 2019 to 2020
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- Year ended 31/12/2020 Gearing: 185,571/(185,571+335,704) x 100 = 35.6%
- Year ended 31/12/2019 Gearing: 240,733/(240,733+292,646) x 100 = 45.1%
- Gearing has improved
Question 2
A business’ statement of financial position is shown below.
Calculate the company’s gearing for both years and state whether gearing has improved or worsened
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- Y/E 31/12/2020 Gearing: 850,000/(850,000+804,508) x 100 = 51.4%
- Y/E 31/12/2019 Gearing 600,000/(600,000+779,660) x 100 = 43.5%
- The gearing has worsened
