CAT / FIA FFA Syllabus H. Interpretation Of Financial Statements - Debt and Gearing Ratios - Notes 4 / 4
Debt Ratio
Total debts
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Total assets
Assets = non-current assets + current assets
Debts include all payables, whether they are due within one year or after more than one year.
Gearing
A company can raise money by loans (Debt) or issuing shares (Equity).
Gearing can be calculated either:
Debt
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Debt + Equity
OR
Debt
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Equity
The gearing ratio is of particular importance to a business as it indicates how risky a business is perceived to be based on its level of borrowing.
High gearing means high debt (in relation to equity). As borrowing increases so does the risk as the business is now liable to not only repay the debt but meet any interest commitments under it. If interest rates increase, then the company could be in trouble unless they have high enough profits to cover this. In addition, to raise further debt finance could potentially be more difficult and more expensive.
Leverage (equity to sales ratio)
Leverage is the converse of gearing, i.e. the proportion of total assets financed by equity.
Shareholder’s equity x 100
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Shareholders’ equity + total long term debt
OR
Shareholder’s equity x 100
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Total assets less current liabilities
Interest Cover
If a company has a high level of gearing it does not necessarily mean that it will face difficulties as a result of this.
For example, if the business has a high level of security in the form of tangible non-current assets and can comfortably cover its interest payments, a high level of gearing should not give an investor cause for concern.
The interest cover is calculated:
Profit before Interest and Tax (PBIT)
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Interest payable
A ratio of at least 3 is deemed to be satisfactory.
The interest coverage ratio is a measurement of the number of times a company could make its interest payments with its earnings.
It is the equivalent of a person taking the combined interest expense from their mortgage, credit cards etc, and calculating the number of times they can pay it with their annual income.
PBIT has its short fallings; companies do pay taxes, therefore it is misleading to act as if they didn’t. A wise and conservative investor would simply take the company’s earnings before interest and divide it by the interest expense. This would provide a more accurate picture of safety.