Gearing ratio does it include tax?

topcat

I have the gearing ratio down as this in book

Loan +preference share capital / loans + preference share capital + equity All X 100

Although in one of the answers they have put tax in the top half of the equation? :-$

SandyHood

Topcat When I've told teachers that there are many definitions of gearing they've been upset. But it is absolutely true. It depends on what you plan to use the gearing ratio to show. I think you need to re-write the quote as the ratio given in the book is .....................Another definition could include all the non current liabilities within the definition of debt, in which case deferred tax would be part of it. If you study credit management the examiner defines gearing as the total debt (made up of long term borrowings, short term borrowings and overdrafts) as a % of the total capital employed.

topcat

Thanks Sandy

This is so confusing though im not sure how to know which one to use ?or even the other variations?

SandyHood

Start by identifying which exam you are studying. Then look at what the gearing ratio will help you to do.

In Credit Control, I would typically use the gearing ratio to asses whether I should grant credit terms to a customer.
For me I want to know how much of a risk of not getting paid exists.
I want to know that I am granting trade credit to a company which is likely to still be in business when the payment is due for the goods we supply.
On this basis total indebtedness is my key. I don't make any distinction between long-term borrowings (such as debentures and loan-stock) and short term loans (from the bank) or overdrafts. They all constitute borrowed funds. What I want to know is what these borrowed funds constitute within the total finance of the company.
If the company has half a million of equity and has borrowings of £2 mill then the gearing is 80% and I'd see this as a negative in my overall credit assessment.

Topcat can you see what I'm getting at?
I have a clear purpose for looking at gearing - I want to know if the risk of the company going into liquidation is high or not

You need to do the same.
And you shouldn't worry about alternative formulae. If you're merely interested in long-term capital structure perhaps for a financial statements type exam, then look at the exam and see if a formula is given. If not, choose one that you think makes sense and stick with it consistently.
I would use long-term borrowings (from the non-current liabilities section of the SFP) and divide it by long-term borrowings + equity
I would ignore deferred tax.

Examiners know that there are loads of gearing ratios around. If they don't tell you which one to use, see if there is room to state your chosen one in words and then just use it. And don't worry if the model answer uses a different one. Remember, model answers do not mean "the only acceptable answers" they are often one answer used by the examiner who recognises that there are several others that as also correct.

topcat

SandyHood wrote: »

Start by identifying which exam you are studying. Then look at what the gearing ratio will help you to do.

In Credit Control, I would typically use the gearing ratio to asses whether I should grant credit terms to a customer.
For me I want to know how much of a risk of not getting paid exists.
I want to know that I am granting trade credit to a company which is likely to still be in business when the payment is due for the goods we supply.
On this basis total indebtedness is my key. I don't make any distinction between long-term borrowings (such as debentures and loan-stock) and short term loans (from the bank) or overdrafts. They all constitute borrowed funds. What I want to know is what these borrowed funds constitute within the total finance of the company.
If the company has half a million of equity and has borrowings of £2 mill then the gearing is 80% and I'd see this as a negative in my overall credit assessment.

Topcat can you see what I'm getting at?
I have a clear purpose for looking at gearing - I want to know if the risk of the company going into liquidation is high or not

You need to do the same.
And you shouldn't worry about alternative formulae. If you're merely interested in long-term capital structure perhaps for a financial statements type exam, then look at the exam and see if a formula is given. If not, choose one that you think makes sense and stick with it consistently.
I would use long-term borrowings (from the non-current liabilities section of the SFP) and divide it by long-term borrowings + equity
I would ignore deferred tax.

Examiners know that there are loads of gearing ratios around. If they don't tell you which one to use, see if there is room to state your chosen one in words and then just use it. And don't worry if the model answer uses a different one. Remember, model answers do not mean "the only acceptable answers" they are often one answer used by the examiner who recognises that there are several others that as also correct.

Thank you very much Sandy it is for the Financial Performance exam .I will mull over this a few times but i can see what you are getting at:thumbup1: