Learning Outcomes
After reading this article, you will be able to explain how a business’s capital structure influences both financial risk and return. You will know how to calculate and interpret gearing and interest coverage ratios, compare sources of finance, and assess their implications for solvency and stakeholder interests. You will be able to apply this knowledge in exam scenarios and in real-world business settings.
ACCA Foundations in Financial Management (FFM) Syllabus
For ACCA Foundations in Financial Management (FFM), you are required to understand the structure of finance in business and the implications this has for management and stakeholders. Make sure you are able to:
- Distinguish between equity and debt as sources of finance for companies
- Define and calculate gearing ratios and interpret their meaning
- Explain the link between high gearing and increased financial risk
- Calculate and interpret interest coverage and explain its significance for solvency
- Assess the consequences of different capital structures for shareholders, creditors, and management
Test Your Knowledge
Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.
- What does a high gearing ratio indicate about a company's capital structure?
- If a business’s operating profit is $600,000 and annual interest payments are $150,000, what is its interest coverage ratio?
- Which source of finance exposes a company to greater financial risk, equity or long-term debt? Briefly explain your answer.
- Why is the interest coverage ratio important for lenders?
Introduction
A business may fund its operations through a combination of equity and debt. The relative balance between these two sources is known as the capital structure. Understanding how this structure affects financial risk and a company’s ability to meet its obligations is essential for stakeholders and exam success.
The main focus of this article is on two interrelated concepts: gearing and interest coverage. Both are key when interpreting financial statements and assessing the stability of a business.
Key Term: gearing
The proportion of a company’s capital financed by debt compared to equity.
GEARING: MEASUREMENT AND INTERPRETATION
What is Gearing?
Gearing measures the extent to which a business is funded by debt as opposed to equity. High gearing means a greater reliance on debt finance, while low gearing reflects a structure dominated by equity.
Two common formulas are:
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Debt/Equity Ratio:
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Debt to Capital Employed Ratio:
Key Term: equity
The residual interest in the assets of an entity after all liabilities have been deducted, typically made up of share capital and reserves.Key Term: long-term debt
Borrowings that are due for repayment after more than one year, such as bank loans or redeemable bonds.
What Does High Gearing Imply?
A highly geared company has a large proportion of finance coming from borrowings. This can increase returns to shareholders when profits are strong, but also increases financial risk if profits fall.
Low gearing means lower financial risk, but possibly lower potential returns for equity holders. Each structure directly affects the company’s ability to respond to economic change and impacts the expectations and security of both lenders and shareholders.
Worked Example 1.1
Assume Alice Ltd has $2 million equity and $1.5 million in long-term loans. Calculate the gearing ratio (using the debt to equity formula) and interpret its meaning.
Answer:
Gearing = $1,500,000 / $2,000,000 × 100% = 75%Interpretation: Alice Ltd is highly geared, relying heavily on borrowed finance. Interest payments will be a significant fixed cost and the company is more exposed to changes in interest rates and earnings volatility.
Consequences of High Gearing
- Potential Benefits:
- Interest costs are generally lower than dividends.
- Interest payments are usually tax-deductible.
- Borrowing allows existing shareholders to maintain control.
- Potential Risks:
- Increased fixed interest payments, which must be paid regardless of profits.
- Higher chance of insolvency if cash flows are inadequate.
- Lenders may impose stricter terms.
Exam Warning
High gearing is not always negative—it may suit stable, cash-generative businesses. However, in exam questions, emphasis is often on the increased risk in adverse conditions. Always link your answer to the specific context provided.
FINANCIAL RISK: DEFINITIONS AND IMPLICATIONS
Financial risk is the risk that a company cannot meet its fixed financial obligations, such as loan interest or repayments. A company with high gearing is more exposed to this risk, since falling profits may quickly lead to inability to pay.
Key Term: financial risk
The risk of a company being unable to meet its financial commitments, especially debt interest and repayments, due to insufficient profits or cash flow.
Borrowing increases financial gearing: when trading is good, profits for shareholders rise faster; when trading deteriorates, losses mount more quickly, and the risk of default increases.
INTEREST COVERAGE: MEANING AND CALCULATION
Interest coverage assesses how comfortably a company can pay its interest charges from operating profit.
Interest coverage ratio =
A low interest coverage indicates risk of default. A high coverage gives security both to the company and to lenders.
Key Term: interest coverage
A ratio showing how many times a company's operating profit covers interest payable on borrowings.
Worked Example 1.2
Beta Co reports an operating profit of $400,000 and pays $50,000 in loan interest for the year. Calculate and interpret the interest coverage ratio.
Answer:
Interest coverage = $400,000 / $50,000 = 8 timesInterpretation: Beta Co can pay its interest expenses from profits 8 times over, which is considered comfortable. Lenders will view this as financially secure.
PUTTING IT ALL TOGETHER: INTERPRETING GEARING AND INTEREST COVERAGE
When examining a business, users should consider both the gearing ratio and interest coverage. High gearing combined with low interest cover is a warning sign. The ability to service debt must align with the company’s profitability and cash flows.
Worked Example 1.3
Delta Ltd and Epsilon Ltd both have operating profits of $200,000. Delta pays $40,000 in interest; Epsilon pays $90,000.
- Delta: interest coverage = 5 times
- Epsilon: interest coverage ≈ 2.2 times
Answer:
Epsilon’s low interest cover indicates higher risk. If profit falls slightly, Epsilon may struggle to pay interest and avoid default. Delta is financially safer.
Revision Tip
Practice calculating both gearing and interest coverage using real company data from recent accounts. Exam questions may provide extracts of financial statements for ratio analysis.
Summary
- Gearing expresses the relationship between debt and equity.
- High gearing increases financial risk but may boost returns when profits rise.
- Interest coverage shows a firm’s ability to meet interest payments from profits.
- Both ratios must be considered together to assess solvency and risk.
Key Point Checklist
This article has covered the following key knowledge points:
- Define and calculate gearing and interpret its significance in assessing business risk
- Distinguish between equity and debt as sources of finance and their effects on stakeholders
- Explain how financial risk increases with reliance on debt finance
- Define and calculate interest coverage and understand its role in financial analysis
- Analyse how high gearing and low interest cover combine to increase insolvency risk
Key Terms and Concepts
- gearing
- equity
- long-term debt
- financial risk
- interest coverage