CIMA F3 Syllabus B. Sources of long term funds - Impact of capital structure on ratios - Notes ^{3 / 4}

The financial risk of a company's capital structure can be measured by

1. gearing ratio

2. debt/equity ratio

3. interest cover

Financial gearing

measures the relationship between shareholders' capital plus reserves, and either prior charge capital or borrowings.

Commonly used measures of financial gearing are based on the statement of financial position values of the fixed interest and equity capital. 

They include:

* Either including or excluding minority interests, deferred tax and deferred income.

Generally, a company is neutrally geared if the ratio is 50%, low geared below that, and highly geared above that.

Gearing ratios based on market values

An alternative method of calculating a gearing ratio is one based on market values:

The advantage of this method is that potential investors in a company are able to judge the further debt capacity of the company more clearly by reference to market values than they could by looking at statement of financial position values.

The disadvantage of a gearing ratio based on market values is that it disregards the value of the company's assets, which might be used to secure further loans.

Changing financial gearing

Financial gearing is an attempt to quantify the degree of risk involved in holding equity shares in a company, both in terms of the company's ability to remain in business and in terms of expected ordinary dividends from the company.

The more geared the company is, the greater the risk that little (if anything) will be available to distribute by way of dividend to the ordinary shareholders. 

The more geared the company, the greater the percentage change in profit available for ordinary shareholders for any given percentage change in profit before interest and tax.

This means that there will be greater volatility of amounts available for ordinary shareholders, and presumably therefore greater volatility in dividends paid to those shareholders, where a company is highly geared. 

Gearing ultimately measures the company's ability to remain in business. A highly geared company has a large amount of interest to pay annually. 

If those borrowings are 'secured' in any way then the holders of the debt are perfectly entitled to force the company to realise assets to pay their interest if funds are not available from other sources. 

Clearly, the more highly geared a company, the more likely this is to occur when and if profits fall.

Interest cover

Like gearing, interest cover is a measure of financial risk which is designed to show the risks in terms of profit rather than in terms of capital values.

As a general guide, an interest cover of less than three times is considered low, indicating that profitability is too low given the gearing of the company.