CIMA BA3 Syllabus D. ANALYSIS OF FINANCIAL STATEMENTS - Gearing Ratios - Notes ^{4 / 5}

This could also be calculated as:

What does the gearing ratio mean?

This ratio is a measure of the relationship between the amount of finance provided by external parties to the total capital employed. 

The more highly geared a business, the more profits that have to be earned to pay the interest cost of the borrowing. 

Therefore, the higher the gearing, the more risky is the shareholder's investment, this is because dividends do not need to be paid unless directors declare them.

So if profits are falling, the directors may decide to only pay the interest cost and no dividends, leaving the shareholder with no dividend income, as the profit was used to pay interest.

What does the interest cover ratio mean?

This is a measure of the number of times that the profit is able to cover the fixed interest due on long term loans. 

It provides lenders with an idea of the level of security for the payment of interest due.

Points to notice about LOW interest cover

low interest cover is a direct consequence of high gearing and . For example,

• It makes profits vulnerable to relatively small changes in operating activity

• So small reductions in sales / margins or small increases in expenses may mean interest can't be paid