Analysis and Communication of Accounting Information — practice questions

Profit per the SoPL can include non-cash items (depreciation, accruals). The SoCF shows actual cash generated ($420,000 from operations), whether the firm can fund investments ($180,000) and dividends ($95,000) without external borrowing, and highlights liquidity risk even when reported profit is higher.

Step 1: Calculate the Gearing Ratio

The gearing ratio measures the proportion of capital financed by debt.

Formula: $\text{Gearing Ratio} = \frac{\text{Non-current liabilities}}{\text{Total Equity} + \text{Non-current liabilities}} \times 100\%$

Calculation: $\text{Gearing} = \frac{\text{\textdollar}800,000}{\text{\textdollar}1,200,000 + \text{\textdollar}800,000} \times 100\% = \frac{\text{\textdollar}800,000}{\text{\textdollar}2,000,000} \times 100\% = 40\%$

Step 2: Calculate the Interest Cover

The interest cover ratio assesses the company's ability to meet its interest payments from its profits.

Formula: $\text{Interest Cover} = \frac{\text{Profit from operations}}{\text{Finance costs}}$

Calculation: $\text{Interest Cover} = \frac{\text{\textdollar}500,000}{\text{\textdollar}100,000} = 5 \text{ times}$

Step 3: Comment on Financial Risk

Alpha plc's gearing of 40% is moderate, indicating that debt finances a significant but not overwhelming portion of the business. The interest cover of 5 times is healthy, suggesting that profits are more than sufficient to cover interest payments, providing a good safety margin. Overall, the financial risk appears manageable, but the company should monitor its debt levels, especially if profitability were to decline.