(173)-ACCOUNTING RATIO ANALYSIS - INTEREST COVER RATIO

Accounting Ratio Analysis – Interest Cover

The interest cover ratio shows whether a company is earning enough profits before interest and tax to pay its interest costs comfortably, or whether its interest costs are high in relation to size of its profits, so that fall in Profit Before Interest and Tax (PBIT) would when have a significant effect on profits available for ordinary shareholders.

Interest cover = Profit before interest and tax / Interest charges

An interest cover of 2 times or less would be low, and should really exceed 3 times before the company’s interest costs are to be considered within acceptable limits.

Although preference share capital is included as prior charge capital for the gearing ratio, it is usual to exceed preference dividends from “interest” charges. We also look at all interest payments, even interest charges on short-term debt, and so interest cover and gearing do not quite look at the same thing.

(172)-THE IMPLICATIONS OF HIGH OR LOW GEARING

The Implications of High or Low Gearing

We mentioned in earlier posts that gearing is, amongst other things, an attempt to quantify the degree of risk involved in holding equity shares in a company, risk both in terms of the company’s ability to remain in business and in terms of expected ordinary dividends from the company. The problem with a high geared company is that by definition there is a lot of debt. Debt generally carries a fixed rate of investment (or fixed rate of dividend if in the form of preference shares), hence there is a given (and large) amount to be paid out from profits to holders of debt before arriving at a residue available for distribution to the holders of equity.

The more highly geared the company, the greater the risk that little (if anything) will be available to distribute by way of dividend to the ordinary shareholders.

The risk of a company’s ability to remain in business was referred to earlier posts. Gearing is relevant to this. A high geared company has a large amount of interest to pay annually (assuming that the debt is external borrowing rather than preference shares). If those borrowings are “secured” in any way (and debentures in particular are secured), then the holders of the debt are perfectly entitled to force the company to realize assets to pay their interest if funds are not available from other sources. Clearly the more highly geared a company the more likely this is to occur when and if profits fall. Higher gearing may mean higher returns, but also higher risk.

(171)-CAPITAL GEARING RATIO

Capital Gearing Ratio

The capital gearing ratio is a measure of the proportion of a company’s capital that is prior charge capital. It is measured as follows:

Capital gearing ratio = Prior charge capital / Total capital

Prior charge capital is capital carrying a right to fixed return. It will include preference shares and debentures.

Total capital is ordinary share capital and reserves plus prior charge capital plus any long-term liabilities or provisions. In group accounts we would also include minority interests. It is easier to identify the same figure for total capital as total assets less current liabilities, which you will find given to you in the balance sheet.

As with the debt ratio, there is no absolute limit to what a gearing ratio ought to be. A company with a gearing ratio of more than 50% is said to be high geared (where low gearing means a gearing ratio of less than 50%). Many companies are high geared, but if a high geared company is becoming increasingly high geared, it is likely to have difficultly in the future when it wants to borrow even more, unless it can also boost its shareholders’ capital, either with retained profits or by a new share issue.

A similar ration to the gearing ratio is the debt/equity ratio, which is calculated as follows.

Debt/equity ratio = Prior charge capital / Ordinary share capital and reserves

This gives us the same sort of information as the gearing ratio, and a ratio of 100% or more would indicate high gearing.

(170)-GEARING RATIO

Gearing Ratio

Capital gearing is concerned with a company’s long-term capital structure. We can think of a company as consisting of fixed assets and current assets (working capital, which is current assets minus current liabilities). These assets must be financed by long-term capital of the company, which is either:

• Share capital and reserves (shareholders’ funds) which can be divided into: Ordinary share plus reserves, and preference shares.
• Long-term debt capital: creditors: amounts falling due after more than one year.

Preference share capital is not debt. It would certainly not be included as debt in the debt ratio. However, like loan capital, preference share capital has a prior claim over profits before interest and tax, ahead of ordinary shareholders. Preference dividends must be paid out of profits before ordinary shareholders are entitled to an ordinary dividend, and so we refer to preference share capital and loan capital as prior charge capital.

(169)-DEBT RATIO

Debt Ratio

The debt ration is the ratio of a company’s total debts to its total assets.

Debt ratio = Total debts / Total assets

• Assets consist of fixed assets at their balance sheet value, plus current assets.
• Debt consists of all creditors, whether amounts falling due within one year or after more than one year.

You can ignore long-term provisions and liabilities, such as deferred taxation.

(168)-LONG TERM SOLVENCY: DEBT AND GEARING RATIOS

Long Term Solvency: Debt and Gearing Ratios

Debt ratios are concerned with how much the company owes in relation to its size, whether it is getting into heavier debt or improving its situation, and whether its debt burden seems heavy or light.

• When a company is heavily in debt banks and other potential lenders may be unwilling to advance further funds.
• When a company is earning only a modest profit before interest and tax, and has a heavy debt burden, there will be very little profit left over for shareholders after the interest changes have been paid. And so if interest rates were to go up (on bank overdrafts and so on) or the company was to borrow even more, it might soon be incurring interest changes in excess of PBIT. This might eventually lead to the liquidation of the company.

There are two big reasons why companies should keep their debt burden under control. There are four ratios that are particularly worth looking at, the debt ratio, gearing ratio, interest cover and cash flow ratio.

(167)-ACCOUNTING RATION ANALYSIS

Return on Shareholders’ Capital (ROSC)

Another measure of profitability and return is the return on shareholders’ capital (ROSC)

ROSC = Profit on ordinary activities before tax / Share capital and reserves

It is intended to focus on the return being made by the company for the benefit of its shareholders.

Return on shareholders capital (ROSC) is not a widely-used ratio, however, because there are more useful ratios that give an indication of the return to shareholders, such as earnings per share, dividend per share, dividend yield and earnings yield.

Analyzing profitability

We often sub-analyze return on capital employed (ROCE), to find out more about why the ROCE is high or low, or better or worse than last year. There are two factors that contribute towards a return on capital employed, both related to sales turnover.

• Profit margin. A company might make a high or low profit margin on its sales.
• Asset turnover. Asset turnover is a measure of how well the assets of a business of a business are being used to generate sales.

ROCE = Profit margin X Asset turnover