Profit and Loss Account - Notes - Business Accounts - Accounting and Finance - Business Studies

Gearing Ratio and Interest Cover Ratio

Most companies have to borrow money if they are to have the funds to expand, and invest in new machinery and equipment. Some of the investment can be funded from profits they have made, or from the issue of shares, but often it has to be borrowed. The more they borrow, the more interest they pay.

This borrowing is a risk because they have to pay the interest whether the investment is a success or not. Even if they are making a loss they still have to pay their interest. Borrowing is thus a risk. The more of their capital that is borrowed, the bigger the risk.

As outsiders looking at a set of accounts we therefore want to assess how big that risk is, and to do this we use another ratio. This ratio is known as the GEARING RATIO. The gearing ratio measures the proportion of the company's total capital that is borrowed, and is calculated as follows:-

GEARING RATIO = Loan Capital
Capital Employed

The capital employed figure on the bottom of the ratio is the total amount of capital the company has at any time. It is the same as the shareholder's equity and is the figure that balances on the balance sheet.

The higher the gearing ratio, the bigger the proportion of the companies money that is borrowed and therefore the bigger the risk. A company with a high gearing ratio is in a very dangerous situation if interest rates are going up. Their interest payable bill will be rising fast, with no corresponding increase in sales revenue. The first thing to suffer is therefore profit.

There is also another measure we can use to assess whether the company is a bit over-exposed to interest rate changes, and that is a ratio called the INTEREST COVER RATIO. This measures how easily the company can pay its interest out of its profit. It is calculated as follows:-

INTEREST COVER = Operating profit
Interest payable

A figure for this of 1 would mean that the company would have to use all its profits to pay its interest bill - not very good news! Any increase in interest rates would leave them in a very delicate situation financially, and profit would inevitably suffer. A figure of 2 or 3 would still be fairly low, but certainly more manageable.

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