Gearing ratio – 6 of 6 in series on financial ratios

In this last post on financial ratios, I will look at some ratios which are of interest to the providers of debt finance i.e. lenders like banks and investors who buy debt in companies instead of shares. We will look at two ratios, the Debt/Equity ration and Interest Cover.

The Debt/Equity ratio is calculated as follows:

Debt/Equity ratio:                                Debt

Equity

Debt is long-term debt, which is normally taken to mean long-term bank loans and other debt finance found under the non-current liabilities heading in the statement of financial position (balance sheet). Equity is the shareholders’ equity, or the capital provided by or attributable to shareholders (typically share capital, accumulated profits and other equity reserves).  In general, if the gearing ratio is greater than 1:1, then a business is said to be lowly-geared; less than 1:1 makes it highly-geared. For a potential investor or lender, the higher the level of gearing the more risky the business may be. From a potential shareholder’s view, if more cash is needed to pay interest on debt, less is available for dividends. From a lender’s view, if the level of existing debt is high, repaying any additional debt may be problematic. However, high gearing is not necessarily a bad thing. Once monies borrowed are put to good use and earn a return greater than the rate interest paid, overall company profits grow. Managers use investment evaluation techniques to select investments (such as building a new production facility) which will produce returns beyond the cost of borrowing.

The next ratio, Interest Cover, is useful to lenders in particular. It is calculated as follows:

Interest Cover:                                    Operating profit

Interest

 The interest cover ratio simply tells us how many times operating profit (which is before interest, tax and dividends) covers interest. From a lenders perspective, a higher level of interest cover is preferred. If the interest cover is low, then a business might have trouble meeting interest payment on borrowings, which certainly would not bode well for repayments of the principal (the amount borrowed).

As in previous posts, let’s now calculate these ratios based on the financial statements of Diageo plc for 2010. The Debt/Equity ratio is as follows:

8177/4786 = 1.7:1 (data from p.108)

This means Diageo plc is a highly geared company. It is however quite successful and generally pays dividends to shareholders, so it most likely uses its debt well.

The interest cover is:

2574/844 = 3.04 times.

This means profit covers interest payments just over three times at current levels, which is reasonable.