gearing ratio: calculation and interpretation

10.2 Analysis of Published Accounts

10.2.1 Liquidity Ratios

Liquidity ratios show a company’s ability to meet its short‑term obligations.

Ratio	Purpose	Formula (LaTeX)
Current Ratio	Measures whether current assets can cover current liabilities.	\displaystyle \text{Current Ratio}= \frac{\text{Current Assets}}{\text{Current Liabilities}}
Acid‑Test (Quick) Ratio	Same as current ratio but excludes inventory (the least liquid current asset).	\displaystyle \text{Quick Ratio}= \frac{\text{Current Assets}-\text{Inventory}}{\text{Current Liabilities}}

Worked Example

Item	£ ‘000
Cash & cash equivalents	500
Trade receivables	300
Inventory	200
Current liabilities	600

Current Ratio = (500 + 300 + 200) ÷ 600 = 1.33 : 1 (or 133 %).

Quick Ratio = (500 + 300) ÷ 600 = 1.33 : 1 (or 133 %). In this case inventory is a small proportion, so both ratios are identical.

Examiner’s Tip

• Always use the same unit (e.g., £ ‘000) for all figures.
• State the ratio as a decimal **and** as a percentage.
• Comment on whether the level is “adequate” (usually > 1) or “tight” (< 1) and why that matters for short‑term risk.

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10.2.2 Profitability Ratios

These ratios assess how efficiently a company turns sales into profit and how well it uses its capital.

Ratio	Purpose	Formula (LaTeX)
Gross‑Profit Margin	Shows the proportion of sales left after the cost of goods sold (COGS).	\displaystyle \text{GPM}= \frac{\text{Gross Profit}}{\text{Sales}} \times 100
Profit Margin (Net)	Shows the proportion of sales that becomes net profit.	\displaystyle \text{PM}= \frac{\text{Net Profit}}{\text{Sales}} \times 100
Return on Capital Employed (ROCE)	Measures profit generated per £ 1 of capital employed (debt + equity).	\displaystyle \text{ROCE}= \frac{\text{Operating Profit}}{\text{Capital Employed}} \times 100

Worked Example (ROCE)

Item	£ ‘000
Operating profit	420
Shareholders’ equity	2 200
Long‑term borrowings	800
Current portion of long‑term debt	200

Capital Employed = Equity + Total Debt = 2 200 + (800 + 200) = 3 200 £ ‘000

ROCE = (420 ÷ 3 200) × 100 = **13.1 %**

Examiner’s Tip

• Distinguish between “gross” and “net” profit – use the appropriate line from the income statement.
• For ROCE, use *operating* profit (EBIT) and *capital employed* (equity + total debt).
• Interpretation should link the percentage to industry norms and to the firm’s strategic objectives (e.g., “ROCE of 13 % exceeds the sector average of 9 % – indicating good use of capital”).

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10.2.3 Financial‑Efficiency Ratios

These ratios gauge how effectively a company manages its working‑capital components.

Ratio	Purpose	Formula (LaTeX)
Inventory Turnover	Number of times inventory is sold and replaced in a period.	\displaystyle \text{Inv Turnover}= \frac{\text{Cost of Sales}}{\text{Average Inventory}}
Receivables Turnover	How quickly sales on credit are collected.	\displaystyle \text{Rec Turnover}= \frac{\text{Credit Sales}}{\text{Average Trade Receivables}}
Payables Turnover	How fast the firm pays its suppliers.	\displaystyle \text{Pay Turnover}= \frac{\text{Purchases}}{\text{Average Trade Payables}}

Quick Example – Inventory Turnover

Item	£ ‘000
Cost of sales (year)	1 800
Opening inventory	300
Closing inventory	500

Average inventory = (300 + 500) ÷ 2 = 400 £ ‘000

Inventory Turnover = 1 800 ÷ 400 = **4.5 times** per year.

Examiner’s Tip

• Use “average” balances (opening + closing ÷ 2) unless the question provides a different figure.
• State the result as “times per year” (or “days” if you convert using 365 ÷ turnover).
• Comment on whether the turnover is high or low relative to the industry and what that implies for cash flow.

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10.2.4 Gearing Ratio

Gearing measures the proportion of a company’s capital that is financed by debt rather than equity – a direct indicator of financial risk.

Key Formulas (choose the one the exam asks for)

Formula	LaTeX	Plain‑text
Debt‑to‑Equity Gearing	\displaystyle \text{Gearing}= \frac{\text{Total Debt}}{\text{Shareholders' Equity}}	Gearing = Total Debt ÷ Shareholders' Equity
Debt‑to‑Capital Gearing	\displaystyle \text{Gearing}= \frac{\text{Total Debt}}{\text{Total Debt}+\text{Shareholders' Equity}}	Gearing = Total Debt ÷ (Total Debt + Shareholders' Equity)

Step‑by‑Step Calculation

1. Extract the figures from the balance sheet (ensure all numbers are in the same unit, e.g., £ ‘000):
   • Long‑term borrowings (bank loans, debentures, bonds).
   • Short‑term borrowings (overdrafts, the current portion of long‑term debt).
   • Shareholders’ equity (share capital + retained earnings + other reserves).
2. Calculate total debt:
   \[ \text{Total Debt}= \text{Long‑term Borrowings}+ \text{Short‑term Borrowings} \]
3. Insert the numbers into the required formula.
4. Convert the decimal result to a percentage (× 100).
5. Classify the level using the benchmark table (see below) and comment on the associated risk.

Worked Examples

Example A – Moderate Gearing

Item	£ ‘000
Long‑term borrowings	1 200
Short‑term borrowings	300
Shareholders’ equity	2 500

Total Debt = 1 200 + 300 = **1 500 £ ‘000**

Debt‑to‑Equity = 1 500 ÷ 2 500 = 0.60 → **60 %**

Debt‑to‑Capital = 1 500 ÷ (1 500 + 2 500) = 0.375 → **37.5 %**

Interpretation: The firm’s capital is 60 % debt (or 37.5 % of total capital). This sits in the “moderate” band – a balanced mix with manageable financial risk.

Example B – High Gearing

Item	£ ‘000
Long‑term borrowings	3 000
Short‑term borrowings	500
Shareholders’ equity	2 000

Total Debt = 3 000 + 500 = **3 500 £ ‘000**

Debt‑to‑Equity = 3 500 ÷ 2 000 = 1.75 → **175 %**

Debt‑to‑Capital = 3 500 ÷ (3 500 + 2 000) = 0.636 → **63.6 %**

Interpretation: Over 60 % of capital is debt – a high‑gearing position that raises financial risk and may constrain dividend payments.

Benchmark Guide to Gearing Levels

Gearing Range	Typical Interpretation	Industry Note
Low – < 30 %	Predominantly equity‑financed; low financial risk but possibly higher overall cost of capital.	Common in utilities and high‑tech start‑ups where cash‑flow stability is vital.
Moderate – 30 % – 60 %	Balanced mix; risk is manageable and the firm can enjoy the tax shield on interest.	Typical for most manufacturing and retail firms.
High – > 60 %	Heavy reliance on debt; higher vulnerability to interest‑rate rises and cash‑flow problems.	Seen in capital‑intensive sectors (property development, airlines).

Key‑Point Box (Examiner’s Expectations)

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10.2.5 Investment Ratios

These ratios are of primary interest to shareholders and potential investors.

Ratio	Purpose	Formula (LaTeX)
Dividend Yield	Return to shareholders from dividends relative to the market price.	\displaystyle \text{Div Yield}= \frac{\text{Dividend per Share}}{\text{Market Price per Share}} \times 100
Dividend Cover	Number of times profit can cover the dividend paid.	\displaystyle \text{Div Cover}= \frac{\text{Profit after Tax}}{\text{Total Dividends Paid}}
Price‑Earnings (P/E) Ratio	Market’s valuation of the company relative to its earnings.	\displaystyle \text{P/E}= \frac{\text{Market Price per Share}}{\text{Earnings per Share}}

Link to Gearing

• High gearing often reduces dividend cover because a larger portion of profit must service debt.
• Investors may demand a higher P/E for low‑geared firms (perceived as safer) and a lower P/E for highly‑geared firms.

Quick Example – Dividend Cover

Item	£ ‘000
Profit after tax	480
Total dividends paid	120

Dividend Cover = 480 ÷ 120 = **4.0 times** (the company could pay four times the current dividend from profit).

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10.2.6 Linking the Ratio Groups

The four groups of ratios interact – a change in one area usually affects the others.

Ratio Group	How It Relates to the Others
Liquidity	Low liquidity may force a firm to raise short‑term debt, raising gearing and affecting interest‑coverage ratios.
Profitability	Higher profit margins improve dividend cover and can support higher gearing (more debt can be serviced).
Efficiency	Improved inventory or receivables turnover frees cash, reducing the need for external financing and thus lowering gearing.
Gearing	Directly influences the cost of capital used in profitability ratios (ROCE) and investment ratios (P/E, dividend yield).
Investment	Investor perception (P/E, dividend yield) feeds back into the firm’s ability to raise equity, which in turn can alter gearing.

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10.2.7 Exam Technique – What Examiners Look For

1. Identify the exact ratio(s) the question asks for.
2. Check that all figures are expressed in the same unit (e.g., £ ‘000).
3. Show every calculation step – extraction, intermediate totals, final formula, conversion to %.
4. Provide a concise interpretation:
   • State the numeric result.
   • Classify the level using the benchmark table.
   • Link the level to financial risk, cost of capital and any strategic implication (e.g., dividend policy, capacity to borrow).
5. If comparing two firms, calculate each ratio, then discuss:
   • Reasons for the difference (different financing policy, industry norm, recent borrowing, etc.).
   • Consequences for investors, lenders and future strategic choices.
6. Common pitfalls to avoid:
   • Confusing total debt with only long‑term debt.
   • Leaving out the current portion of long‑term borrowings.
   • Failing to convert a decimal to a percentage.
   • Providing only a definition of the formula without performing the calculation.

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10.2.8 Putting It All Together – Quick Summary

• Liquidity ratios test short‑term solvency (Current ≥ 1, Quick ≥ 1 is generally acceptable).
• Profitability ratios show how well the business turns sales into profit (higher margins and ROCE are better).
• Efficiency ratios reveal how quickly assets are turned over – faster turnover usually improves cash flow.
• Gearing ratio measures financial risk; classify as low (< 30 %), moderate (30‑60 %) or high (> 60 %).
• Investment ratios reflect shareholder returns; they are influenced by profitability and gearing.
• All groups are inter‑linked – e.g., better efficiency can lower gearing, lower gearing can improve dividend cover, and higher profitability can support both lower risk and higher shareholder returns.