Financial Position Analysis

When assessing the financial position of a business the main focus is its stability and exposure to risk. This is typically assessed by considering the way the business is structured and financed. This is referred to as gearing.

In simple terms gearing is a measure of the level of external debt a company has (e.g. outstanding loans) in comparison to equity finance (i.e. share capital and reserves).

Measuring gearing

There are two methods commonly used to express gearing as follows.

Debt/equity ratio:

This is calculated as:

Long-term debt / equity x 100

Percentage of capital employed represented by borrowings:

This is calculated as:

Long-term debt / (equity + long-term debt) x 100

Long term debt includes non-current loan and redeemable preference share liabilities.

Equity includes share capital (and premium) balances plus reserves (revaluation reserve, retained earnings).

NB: redeemable preference shares are treated as liabilities because they must be repaid and are therefore debts of the company. Irredeemable preference shares do not have to be repaid and are therefore treated the same as ordinary shares and included in equity.

High and low gearing

Risk

External debt finance is considered to be risky because there are mandatory, fixed repayment obligations. Failure to repay these amounts could lead to insolvency proceedings against the company.

Equity finance is less risky because there are no mandatory repayment obligations to shareholders. Failure to pay a dividend would not lead to insolvency proceedings.

Servicing of finance

The costs of servicing equity finance are generally considered to be higher than servicing external debt. This is because equity holders expect a greater return than they could achieve offering a fixed loan to a company. Remember lenders received fixed, mandatory repayments. They also take out security on the assets of a company. Equity holders do not have this comfort blanket; they get no guaranteed returns and they take on considerable risks. They would therefore expect greater returns on their investments; if they could not achieve this they would surely not accept the risk of buying shares and lend their money instead.

Therefore highly geared companies (high level of debt to equity) are considered to be riskier but comparatively cheaper to service than lower geared companies (and vice versa).

Low-geared businesses also tend to provide scope to increase borrowings when potentially profitable projects are available as they are generally perceived to be less risky by banks and can therefore borrow more easily.

Interest cover

This is calculated as:

Profit before interest and tax / interest payable

Interest cover indicates the ability of a company to pay interest out of profits generated:

• low interest cover indicates to shareholders that their dividends are at risk (because most profits are eaten up by interest payments) and
• the company may have difficulty financing its debts if its profits fall
• interest cover of less than two is usually considered unsatisfactory.

A business must have a sufficient level of long-term capital to finance its long-term investment in non-current assets. Part of the investment in current assets would usually be financed by relatively permanent capital with the balance being provided by credit from suppliers and other short-term borrowings. Any expansion in activity will normally require a broadening of the long-term capital base, without which 'overtrading' may develop (see below).

Suitability of finance is also a key factor. A permanent expansion of a company's activities should not be financed by temporary, short-term borrowings. On the other hand, a short-term increase in activity such as the 'January sales' in a retail trading company could ideally be financed by overdraft.

A major addition to non-current assets such as the construction of a new factory would not normally be financed on a long-term basis by overdraft. It might be found, however, that the expenditure was temporarily financed by short-term loans until construction was completed, when the overdraft would be 'funded' by a long-term borrowing secured on the completed building.

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