Gearing Ratio - Credit management and Controls project

Loz1234

Hi!!

I am doing the practice assessment for the credit management and controls project from the AAT website and am stuck with the gearing ratio.

I have printed the answer booklet so I know what it should be but cannot work it out. I know the ratio is Long term debt / Capital employed x 100% but I cannot get the answer from the figures I have, can anyone help?????

Here are the figures I am working with

Fixed Assets
Tangible assets 2200

Current Assets
Stocks 900
Trade Debtors 1000
Cash 50
1950

Creditors amounts due within 1 year
Trade Creditors 2100
Net current assets -150

Creditors amounts due after 1 year
Long term loans 1000
Net assets 1050

Capital and Reserve
Share Capital 200
Profit and loss account 850
Shareholders funds 1050


I have been doing 1000/1050 x 100 = 95.24% but the answer on the booklet is 48.78%.

Can anyone help a very confused and tired lady??

uknitty

Try thinking of it as long term debt over the Total Equity Available (not just the shareholders capital) and you should get to the answer.

Loz1234

Sorry I must be thick I really can't get it.

Just think I've hit my stumbling block with this unit. :-(

uknitty

OK, gearing measures how much equity you have available and what percentage of that equity is debt.

If you look at the figures again try and calculate how much money is available from all sources. You have Shareholders Capital, Retained Profit and there is something else you are missing..... It's one of those can't see the wood for the trees type of things


CMCC is a really, really tough unit. In fact all of level 4 is really tough going. Don't feel bad - I'm making tons of mistakes at this level !

Paisley

Hi Loz

I remember the gearing ratio as:

Non-current liabilities / Non-current liabilities + Equity x 100

That will give you the 48.78%

Loz1234

Thanks uknitty!!

Think I just need to put my books down and come back to them tomorrow and hopefully it will all make sense.

Yeah I've found level 4 tough. I've only got this unit, ICAS and financial statements to do then I'm done. I'm so dreading financial statements though, it looks horrifying!!

Have you done CMCC?

Loz1234

Paisley, thanks to you also!!

I'm putting the books to bed now until tomorrow lunch time, when I'll study in my lunch hour :-(

uknitty

OK well all you need to do is remember that the long term debt is also equity. The figure should be included on both the top and bottom line.

That gives you 1000/(1050+1000) *100 = 48.78 %


ETA: Which is exactly the same as what Paisley just said

I did CMCC under the "old" standards so I am exempt from it at level 4 under new standards. I have sat FNST and it was horrid (more because I had technical issues and the computer crashed wiping out my written answer :O fairly sure I will need a resit !) I'm studying budgeting right now with a view to doing the exam in October

Paisley

Loz1234 wrote: »

Paisley, thanks to you also!!

Hope it helped

I did this unit recently, so it's still fresh in my mind.

The gearing ratio shows what proportion of the company's capital is made up of loans. If the result is over 50%, the company is said to be 'high geared'. This is not great from the shareholders' point of view as higher loans mean higher loan and interest repayments, resulting in lower profit for sharing.

Henry

Loz1234,
I just wanted to point out that your answer of 95.24% is also correct. Gearing can either be taken as Debt/Equity or Debt/(Equity + Debt). It is just that the book answer used the second formula but your approach is also correct. It is a bit similar to Earnings Per Share where you can have two different calculations to arrive at it. Perhaps in an exam you could put both answers.

MarkHorley

Hi there, using the same practice assessment is the gearing ratio laid out in words as

Long term loans 1000/(Long term loans 1000+Net assets 1050) x100=48.78

I'm just trying to set it right in my mind what words to look for....

Thanks in Advance

PS sitting CMAC tomorrow....

SandyHood

I included gearing ratios in my class yesterday.

A lot of the comments in this thread are fine.

I think that we must focus on the use of a ratio - something that becomes more and more important as you progress through your accountancy qualifications.
In this exam, we look at gearing with the purpose of making a judgement about the suitability of a client for credit.
One of the earlier responses looked at prospective shareholders, but we are a company selling things to another company. And we want to try to minimise the risk that we allow credit facilities to a client that does not pay.

Once you are thinking about what information you want, then you can put gearing into context.

My class (poor soles) had to get their heads around what on earth I mean by debt.
Look in a text book and the chances are that you'll see a definition of gearing being:
Long term liabilities ....... x 100 = ...%
Equity + Long term liabilities

But, although this is a perfectly acceptable college student definition of gearing it is not good enough for a decent credit controller.

We need to ask the right questions, not simply get the answer right.

A customer that has paid off long-term liabilities by borrowing short term and increasing the overdraft hasn't increased the credit worthiness. This is window dressing.

If you are going to do a good job of judging the gearing you have to take account of the short term debt.

So you might use this definition of gearing:
Short term debt AND Long term liabilities ....... x 100 = ...%
Equity + Long term liabilities AND short term debt

or even (but probably not as part of a debt management CBE)
Total of current liabilities plus Non current liabilities....../... x 100 = ....%
Equity + Total of current liabilities plus Non current liabilities

This now means that you MUST READ your exam questions VERY CAREFULLY . And if necessary, state your assumptions. Remember this is an exam read and marked by a human being rather than a computer. So you can clarify points in a way that is not available in the computer marked ones.

As a class question we looked at assessing the credit worthiness of two possible new credit customers and whether an existing credit customer was worthy of having an increased limit. I had written the question and defined gearing as:
......Total debt.........
Total debt + Equity

As you may now realise (although I hadn't thought so when I wrote it) this is ambiguous

Total debt would definitely mean Long-term debt and short-term debt, but what about tax liabilities or trade creditors?
We had to agree as a class. (On this occasion we agreed that we would only include long term debt, short term loans and overdrafts). But it goes to show that clarification might be necessary.
If I had set it for homework and taken it in, I would have looked for

1. an assumption about what was meant by total debt
2. the consistent use of that definition in the calculations

SandyHood

Here is Loz's data:

Here are the figures I am working with

Fixed Assets
Tangible assets 2200

Current Assets
Stocks 900
Trade Debtors 1000
Cash 50
1950

Creditors amounts due within 1 year
Trade Creditors 2100
Net current assets -150

Creditors amounts due after 1 year
Long term loans 1000
Net assets 1050

Capital and Reserve
Share Capital 200
Profit and loss account 850
Shareholders funds 1050

The client has long term loans worth £1000
And shareholders' funds of £1050
There are no short term loans
There is no overdraft
But trade creditors are owed £2100

The standard formula should work here
...... Long term loans ........................... x 100 .........................£1000................. x 100 = 48.78%
Long term loans + Shareholders funds ....................................£1000 + £1050


I'd be happy enough with this as a ratio.

Now I digress away from gearing

But I would want to know more about the working capital of this prospective client.
The net current asset value is negative
What industry is this business in?
If it is a super market, and we sell groceries that would be fine. But if they manufacture, I would be very concerned.

So look at every relevant bit of information when you weigh up prospective credit customers.

reader

Hi Sandy

Brilliant explanation.

Re: supermarkets and manufacturers; is it OK for a supermarket to have a negative net current asset value because supermarkets can sell the goods they've bought on credit very quickly?

SandyHood

Thank you reader. I agree - yes net current liabilities
I added something which I am sure you took for granted.

reader wrote: »

Hi Sandy

Brilliant explanation.

Re: supermarkets and manufacturers; is it OK for a supermarket to have a negative net current asset value because supermarkets can sell for cash the goods they've bought on credit very quickly?