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w Thief searchssearchasearchcsearch5 Gearing, or leverage, describes the mix of long-term corporate funding provided internally (by shareholders) to that contributed externally (by lenders). Interpreting financial statements using ratio analysis, an integral element of the paper 1 syllabus, demands considerably more than just the ability to calculate key gearing ratios. Ratios are a set of tools to enable the user to gain a deeper insight into a company (to facilitate planning, decision-making and control) â?” they are a means to an end, not the end in themselves. An appreciation of the factors that influence a companyâ?™s gearing and the effects of gearing on shareholders returns are vital to interpreting gearing ratios. These two themes are covered in this article, together with the key gearing ratios. To prevent students from adopting a piecemeal approach to the interpretations of financial statements, the article places the gearing ratios into a systematic framework of analysis, which highlights the inter-relationships between the key categories of ratios. Factors affecting the level of gearing employed by a company Before gearing ratios can be properly understood, it is instructive to analyse the factors
| Measuring gearing â?” key ratios | ||
|---|---|---|
| Capital gearing ratio | = | Prior charge capital |
| Capital employed | ||
| Debt-equity ratio | = | Prior charge capital |
| Ordinary share capital + reserves | ||
| Interest cover | = | Profit before interest and tax |
| Interest charges | ||
| Cash flow ratio | = | Net cash flow from operations |
| Total debts |
The capital gearing ratio measures the proportion of a companyâ?™s capital that is prior charge capital. Prior charge capital represents capital carrying a right to a fixed return (e.g., debentures and preference shares). Capital employed represents the long-term funding of a business â?” ordinary share capital and reserves, preference shares and long-term liabilities and provisions. In group accounts, minority interests would also be included. There is no limit to what the capital gearing ratio should be, though a benchmark to differentiate low from high gearing is 50%. Above 50%, a company would be highly-geared and if the companyâ?™s gearing was rising, it could encounter difficulties in the future in raising additional debt finance unless it could also raise shareholdersâ?™ funds, either through a share issue or retained profits.
A very similar ratio to capital gearing is debt-equity. The only difference between the two ratios is in the choice of denominator. Debt-equity expresses prior charge capital to ordinary shareholdersâ?™ funds, whereas capital gearing relates prior charges to total capital. A debt-equity ratio exceeding 100% would indicate high gearing.
The major obligations imposed upon companies raising debt finance are the requirement to pay interest on the loan and ultimately to repay the amount borrowed (principal). The times interest cover ratio assesses the ease with which companies can meet their interest payments from operating profit. Interest charges relate to interest on long-term loans (due after more than one year) and should be taken gross, and not net, of interest receipts. If the profit cover for interest is low then the ability of the business to raise additional debt finance will be restricted. Again trends (and industry norms) are more important than the absolute level of cover, though a benchmark figure of around three would indicate satisfactory cover. Research has shown that declining interest cover is a useful predictor of business failure (see Letza, S.R. â?˜ The strengths and weaknesses of traditional ratio analysisâ?™ Studentsâ?™ Newsletter, May 1995). However, one of the weaknesses of the interest cover ratio is that it fails to acknowledge that it is cash, not profit, that is used to service debt. This is the rationale for the cash flow ratio.
The cash flow ratio utilises the cash flow statement figure for net cash flow from operations and compares it with total debts (including short- and long- term creditors, together with provisions for liabilities and charges). The ratio could be manipulated to distinguish between debts payable within one year and those payable at a later date. The two requisites for long-term corporate survival are profitability and the ability to meet obligations as they fall due for payment. The cash flow ratio, monitored over time, should provide a useful insight into a companyâ?™s ability to generate cash from its operations to meet its foreseeable debts and future commitments.
When interpreting accounts, students must see the linkages across the five categories of ratios and not confine discussion to changes in each of the five. Whilst valuable marks are available for calculating ratios correctly, a greater number of marks will always be awarded to those candidates able to make sense of the ratios. In order to analyse a set of company accounts, it is useful to compute ROCE first, the primary ratio. This enables a breakdown into the causes of trends in ROCE to be investigated, using the secondary ratios.
| ROCE | = | PBIT x 100% | |
| Capital employed | |||
| ROCE | = | net profit margin x capital employed turnover | |
| PBIT x 100% | x Sales | ||
| Sales | Capital employed |
The secondary-ratios (net margin and capital employed turnover) will estabilish whether variability in ROCE is due to changes in profit margin and/or efficiency, enabling a more focused analysis. If the former is the case, comments should centre upon ways of increasing revenue (e.g., changing the sales mix, volume, selling price, and analysing the elasticity of demand for the product), and controlling expenses (e.g., bulk discounts in purchases, managing wage inflation, administration costs, etc.) Extra ratios could be computed (e.g., overheads/sales). If variation in ROCE is due to the utilisation of capital employed to generate sales, then a battery of efficiency ratios should be examined. Profitability and efficiency levels will feed through into the companyâ?™s liquidity ratios.
Given that operating profit adjusted for depreciation and changes in working capital, equals cash from operations, one would expect a strong P&L to feed into cash generation. This cash may then be reinvested elsewhere in the business (e.g., in additional fixed assets, stocks and debtors) or in repaying debt, paying creditors, tax, interest, or dividends. Similarly, effective control of the elements of working capital (stock, debtors and creditors) should show through in sound liquidity ratios. In contrast, if companies hold stock for lengthy periods and take a long time to collect money from debtors they would be expected to have weaker liquidity than similar company utilising a JIT stock system and employing efficient credit control techniques.
Gearing levels will also influence liquidity. In the same way that individuals with large mortgages have to pay a large slice of their income to service their debt, so too must highly-geared companies. This, therefore, reduces corporate cash flow, and will be picked up in the acid test and current ratios. Gearing, through the financial risk effect (discussed below), also influences the returns available to shareholders, captured by investor ratios, ceteris paribus, when times are good more highly-geared companies will generate higher returns (earning per share, ROSF) for their shareholders than predominantly equity-financed companies. The effects of gearing on the owners of a company are discussed below, within a broad framework which criticaly evaluates the use of loan cpaital in the capital structure.
To illustrate the effect of gearing on owners, three companies with identical trading records and capital employed are considered. However, the manner in which each is financed differs. Company 1 is funded solely by equity, whereas companies 2 and 3 employ a mix of equity and debt with the latter being highly-geared.
| Company 1 | Company 2 | Company 3 | |
| £000 | £000 | £000 | |
| Net assets | 1000 | 1000 | 1000 |
| Equity | 1000 | 700 | 300 |
| Debt (10%) | 0 | 300 | 700 |
| 1000 | 1000 | 1000 |
In year 1, the following information is available:
| Company 1 | Company 2 | Company 3 | |
| £000 | £000 | £000 | |
| Sales | 1200 | 1200 | 1200 |
| PBIT | 120 | 120 | 120 |
| Interest (10%) | 0 | 30 | 70 |
| Profit before tax | 120 | 90 | 50 |
| Taxation (50%) | 60 | 45 | 25 |
| Profit after tax | 60 | 45 | 25 |
| Operating margin | 10.0% | 10.0% | 10.0% |
| ROCE | 12.0% | 12.0% | 12.0% |
| ROSF | 6.0% | 6.4% | 8.3% |
Suppose in year 2 that profitability improves for each company, with operating margin rising from 10% to 15% (the same results for ROSF would be generated if the margin remained at 10% and sale rose to £1.8m).
| Company 1 | Company 2 | Company 3 | |
| £000 | £000 | £000 | |
| Sales | 1200 | 1200 | 1200 |
| PBIT | 180 | 180 | 180 |
| Interest (10%) | 0 | 30 | 70 |
| Profit before tax | 180 | 150 | 110 |
| Taxation (50%) | 90 | 75 | 55 |
| Profit after tax | 90 | 75 | 55 |
| Operating margin | 15.0% | 15.0% | 15.0% |
| ROCE | 18.0% | 18.0% | 18.0% |
| ROSF | 9.0% | 10.7% | 18.3% |
Gearing â?” the advantages