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Summary Knowledge clip - financial ratio analysis and financial gearing (Operational Management)
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Summary knowledge clip financial ratio analysis and financial gearing
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Knowledge clip, financial ratio analysis/ financial gearingFinancial gearing
Financial gearing is the extent to which a company is capable of settling its non-current liabilities or
also named long-term debts. So in other words, is the company able to repay my long-term debts to
the investors?
Example
Company A Company B
Assets 100 Equity 10 Assets 100 Equity 80
Liabilities 90 Liabilities 20
In case of bankruptcy the estimated value of the assets (forced sale) is 50 for both companies, which
is all the information you have.
If a company is highly geared then this means that they have a lot debt compared to the equity in the
company.
So, more debt compared to equity.
Company A is highly geared. Therefore, this company is a higher risk to lenders and this can also
discourage investors as they might lose their money if they invest in this company.
Furthermore, by looking at the financial gearing and also the forced sale, you see that company A has
a forced sale of 50, while the liabilities are 90, so the investors of the debt capital (liabilities) have a
higher risk because they won’t get their money back in case of bankruptcy. In the case of company B
the risk is lower, because the company is able of paying their debts.
Solvency (gearing) ratios
Gearing ratio
(Non-current liabilities / share capital + reserve + non-current liabilities) x 100%
Please note: share capital and reserves together are equity capital). Furthermore, the lower the
amount is, the better!
Interest cover ratio
Operation profit / interest payable
Solvency (gearing) ratio analysis
Can help you with longer term strategic decision making. Very important for stakeholders who you
are seeking to give your long-term investment.
Also, for your current investors; how high is their risk?
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