## 1 Financial Gearing Ratios

Financial Gearing ratios can be calculated in number of ways. Below given financial gearing ratios are the most commonly used ratios in management accounting. However, all the ratios determine the ratio or percentage of long term liabilities in capital used to purchase total assets.

### 1.1 Debt to Equity Ratio

Formula:

*Where*

Non-current liabilities divided by Equity.

It is also presented in percentage by multiplying it with 100.

Debt to equity ratio above 100% is considered as high.

It measures financial gearing and reflects financial risk faced by the organization.

Increase in financial gearing increases financial risk.

Illustration:

SFP (extract) at the year-ended | 30 May 2010 | 30 May 2011 | ||

$ | $ | $ | $ | |

Non-current liabilities | ||||

5% Redeemable preference shares | 1,000 | 1,000 | ||

Bank loan | 1,200 | 1,000 | ||

Non- current liabilities | 2,200 | 2,000 | ||

Equity | ||||

Ordinary Share capital | 3,000 | 3,000 | ||

Share premium | 5,000 | 5,000 | ||

Retained earnings | 4,000 | 4,500 | ||

Other reserves | 1,000 | 1,000 | ||

Equity | 13,000 | 13,500 |

Required:

Calculate Debt to Equity ratio and interpret the results?

Solution:

Formula:

**Debt to Equity ratio (2010)**

It suggests that non-current liabilities to finance assets are $0.17 to $1 of equity capital invested.

**Debt to Equity ratio (2011)**

It suggests that non-current liabilities to finance assets are $0.15 to $1 of equity capital invested.

**Growth/(Decline) rate**

It suggests that financial gearing is decreased by 11.76%.

Decreased financial risk due decreased profit volatility due to interest expenses.

### 1.2 Debt to Debt plus Equity Ratio

Formula:

Non-current liabilities divided by non-current liabilities plus equity.

It is also presented in percentage by multiply it with 100. Debt plus debt to equity ratio above 50% is considered as high.

It also measures financial gearing just as above ratio. It results in different figure but same conclusion.

Exam Support:

Formula sighted by the examiner should be used in all cases. You should look at the information given in the question such as choices given in MCQs. If choices are below 100% then you must use debt to debt plus equity ratio rather than debt to equity ratio.

Illustration:

SFP (extract) at the year-ended | 30 May 2010 | 30 May 2011 | ||

$ | $ | $ | $ | |

Non-current liabilities | ||||

5% Redeemable preference shares | 1,000 | 1,000 | ||

Bank loan | 1,200 | 1,000 | ||

Non- current liabilities | 2,200 | 2,000 | ||

Equity | ||||

Ordinary Share capital | 3,000 | 3,000 | ||

Share premium | 5,000 | 5,000 | ||

Retained earnings | 4,000 | 4,500 | ||

Other reserves | 1,000 | 1,000 | ||

Equity | 13,000 | 13,500 |

Required:

Calculate Debt over Debt plus Equity ratio and interpret the results?

Solution:

Formula:

**Debt to Debt plus Equity ratio (2010)**

It suggests that non-current liabilities to finance assets are $0.14 to $1 of total capital invested.

**Debt to Debt plus Equity ratio (2011)**

It suggests that non-current liabilities to finance assets are $0.13 to $1 of total capital invested.

**Growth/(Decline) rate**

It suggests that financial gearing is decreased by 7.14%.

Decreased financial risk due decreased profit volatility due to interest expenses.

### 1.3 Interest Cover (Times)

Formula:

Operating profit divided by interest expense.

It suggests how many times operating profit is able to pay interest expense. It represents security to the debt finance providers.

It also represents financial risk to business. If business failed to pay interest expense, then debt providers can force it into liquid

Decrease in interest cover increases financial risk.

Illustration:

SOCI (extract) for the year-ended | 30 May 2010 | 30 May 2011 | ||

Workings | $ | Workings | $ | |

Sales revenue | (10,000 x $3) | 30,000 | (11,000 x $4) | 44,000 |

Variable cost | (10,000 x $2) | 20,000 | (11,000 x $2) | 22,000 |

Gross profit | 10,000 | 22,000 | ||

Fixed cost | 5,000 | 17,000 | ||

Net Profit | 5,000 | 12,000 | ||

Interest expense | (50 + 120) | 170 | (50+100) | 150 |

Profit before tax | 4,830 | 11,850 |

Required:

Calculate interest cover and interpret the results?

Solution:

Formula:

**Interest cover (2010)**

It suggests that 29 times interest can be paid out of net profit

**Interest cover (2011)**

It suggests that 80 times interest can be paid out of net profit

**Growth/(Decline) rate**

It suggests that interest cover is increased by 175%.

Decrease financial risk due increased ability to pay interest expenses.

Increased security to debt holders.