9609 · 10.2.4
Practice and worked examples for 9609 Gearing ratio. Short previews only — attempt the full question in MarkScheme against the official scheme.
Equity $400 000; non-current liabilities $300 000; operating profit $80 000; finance costs $24 000.
Calculate gearing and interest cover. Comment.
Capital employed = 400 000 + 300 000 =
Gearing = (300 000 ÷ 700 000) × 100 = 42.9%
Interest cover = 80 000 ÷ 24 000 = 3.3 times
Comment: Moderate gearing — debt is significant but interest is covered 3.3× by operating profit. If profits fall sharply, cover could become strained. Compare trend and industry.
A manufacturing company, 'BuildStrong Ltd', provides the following extracts from its Statement of Financial Position for two consecutive years.
| Item | 2022 ($'000) | 2023 ($'000) |
|---|---|---|
| Non-current liabilities | 1,200 | 2,000 |
| --- | --- | --- |
| Shareholders' funds | 2,800 | 3,000 |
Calculate the gearing ratio for both years and comment on the change in the company's financial risk.
Step 1: State the formula Gearing Ratio = (Non-current liabilities / Capital employed) × 100 Capital Employed = Non-current liabilities + Shareholders' funds
Step 2: Calculate for 2022 Capital Employed (2022) = 2,800,000 = Gearing (2022) = (4,000,000) × 100 = 30.0%
Step 3: Calculate for 2023 Capital Employed (2023) = 3,000,000 = Gearing (2023) = (5,000,000) × 100 = 40.0%
Step 4: Comment on the change BuildStrong Ltd's gearing ratio increased from 30% in 2022 to 40% in 2023. This indicates that the company has taken on more long-term debt relative to its equity base, increasing its financial leverage. While a 40% ratio is still considered moderate for a manufacturing firm, the upward trend signifies a rise in financial risk. The company is now more vulnerable to increases in interest rates and must ensure its operating profits are sufficient to cover the higher interest payments. This strategy may be to fund expansion, but stakeholders would want to see a corresponding increase in profitability (ROCE) to justify the added risk.