Risk ratios (gearing and interest cover)

Introduction to Risk Ratios

Welcome! In this section, we are diving into Risk Ratios (also known as Solvency or Gearing Ratios). If you have ever wondered how a company balances using its own money versus borrowing from a bank, you are in the right place!

Analysis of financial statements isn't just about how much profit a company makes; it's also about how safe that company is. Risk ratios help us understand the long-term stability of a business. Specifically, we want to know: Has the company borrowed too much? and Can it afford to pay the interest on its loans?

Don't worry if these terms sound a bit scary at first. We will break them down into simple pieces using everyday examples!

1. Understanding Gearing

Gearing (often called leverage) measures the relationship between the money provided by the owners (Equity) and the money borrowed from outside sources (Long-term Debt).

The Concept: The House Analogy

Imagine you buy a house for \$200,000. You pay \$20,000 from your savings (Equity) and borrow \$180,000 from the bank (Debt). In business terms, you are highly geared because most of the house is paid for with borrowed money. If you paid \$150,000 in cash and borrowed only \$50,000, you would be low geared.

How to Calculate Gearing

In the CIMA BA3 syllabus, there are two common ways to calculate Gearing. Always check the data provided in your exam question!

Method A: Debt to Equity
\nThis compares what is owed to what is owned by the shareholders.
\n\( \text{Gearing} = \frac{\text{Long-term Debt}}{\text{Total Equity}} \times 100 \)

Method B: Debt to Total Capital (Most Common)
\nThis compares the debt to the total long-term funding in the business.
\n\( \text{Gearing} = \frac{\text{Long-term Debt}}{\text{Long-term Debt} + \text{Total Equity}} \times 100 \)

Note: Total Equity includes Share Capital and Retained Earnings. Long-term Debt usually refers to Non-current Liabilities like bank loans or debentures.

What do the results mean?

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• High Gearing (usually over 50%): The company relies heavily on debt. This is risky because interest must be paid regardless of whether the company makes a profit.
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• Low Gearing (usually under 25%): The company is financed mainly by its owners. This is generally seen as "safer," but it might mean the company isn't using debt to grow as quickly as it could.
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Quick Review: Gearing tells us about the capital structure. High gearing = high financial risk!

2. Interest Cover

While Gearing looks at the Balance Sheet, Interest Cover looks at the Income Statement. It tells us how easily a company can pay the interest on its debts out of its yearly profits.

The Formula

To calculate Interest Cover, we look at how many "times" the profit can cover the interest bill:
\n\( \text{Interest Cover} = \frac{\text{Profit Before Interest and Tax (PBIT)}}{\text{Interest Expense}} \)

Why use PBIT? We use Profit Before Interest and Tax because that is the total "pot" of money available to pay the lenders before the government takes its share in tax.

An Everyday Example

Think of your monthly salary. If your salary is \$3,000 and your monthly loan interest is \$300, your "interest cover" is 10 times. You are very safe! But if your interest was \$2,500, you would only have a cover of 1.2 times. One small drop in salary, and you couldn't pay the bank.

Interpreting the Result

• High Interest Cover (e.g., 10 times): Very safe. The company earns plenty of profit to pay its lenders.
• Low Interest Cover (e.g., below 2 or 3 times): Dangerous. If profits drop slightly, the company might default on its interest payments, which could lead to bankruptcy.

Memory Aid: Think of Interest Cover as a "Safety Blanket." The bigger the number, the thicker the blanket protecting you from the cold (financial failure)!

3. Why Risk Ratios Matter to Stakeholders

Different people look at these ratios for different reasons:

1. Ordinary Shareholders: They worry about high gearing because interest is paid before dividends. If interest costs are too high, there might be nothing left for the owners!

2. Lenders (Banks): They look at interest cover to see if they will get their interest payments on time. They look at gearing to see if the company is already "maxed out" on its credit cards.

Common Mistakes to Avoid

• Using the wrong profit figure: For Interest Cover, always use Operating Profit (PBIT). Do not use Gross Profit or Net Profit.
• Forgetting the 100: Gearing is expressed as a percentage (%), while Interest Cover is expressed as "times."
• Mixing up Debt and Equity: Remember that Equity is the owners' money; Debt is the bank's money.

Summary Checklist

Before moving on, make sure you can answer these questions:

• Can you calculate Gearing using both the Debt/Equity and Debt/Total Capital methods?
• Do you know that Capital Employed is just Equity + Long-term Debt?
• Can you explain why a low Interest Cover ratio is a warning sign for a business?
• Do you understand that high gearing makes a company more vulnerable to increases in interest rates?

Key Takeaway: Risk ratios are all about long-term survival. Gearing looks at the source of the money, and Interest Cover looks at the affordability of the debt.

Keep practicing these calculations! The more you do, the more natural it will feel to spot which company is "safe" and which is "risky." You've got this!