Ratio analysis: Risk, Return and NAV
RISK
1) DEBT: EQUITY GEARED
o Debt to equity ratio gives the readers of the FS an idea of the extent to which a
business is financed by borrowed capital and therefore the degree of risk that
business has placed itself in
What is risk?
o The ratio between own and borrowed money in which the company is financed.
o Indication of how a business is financed capital provided by s/holders or borrowing
money
o Borrowed capital (loans) = greater financial risk because of interest
o If business relies mainly on s/holders to fund operations = low risk
What does this mean? It means uncertainty, the possibility of losses/failure/negative
outcome.
For companies in accounting this is risk of financial distress.
Use the Debt: Equity ratio to measure risk.
o Debt means non-current liabilities (loans)
o Equity includes both Ordinary Share Capital (OSC) and Retained Earnings/Income
(RI)
o Tells the readers how a business is financed / the extent to which the business is
financed by borrowed capital (loans) and own capital (equity).
Debt is risky as it bears interest (shares do not) and must also be repaid at some point.
Therefore, if the business gets into a place of financial distress (losses), then there is the
risk of defaulting on interest and loan payments, and this could cause the business to
become insolvent (close down).
We call this relationship between debt and equity Geared. If the business is financed more
by debt (ie ratio is more than 1:1) then we say the company is highly geared which is
risky. If the ratio is less than 1, then the business is financed more by equity and is lower
risk.
o If business issued shares to finance a payment and the D:E ratio decreased
therefore the business should have rather taken out a loan to finance the payment
High risk
o If company has high net profit, they would be able to repay its debt quickly
o Debt may be high because a loan was taken out to finance acquisitions
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