Another greenlight confusion

zaf1987

Question 7

Now i got first one right and last, but for the gearing ratio i did total debt/total equity x 100. I was under impression that this was equally valid way of calculating gearing ratio.
[h=3]Explanation of the correct answer:[/h] Interest cover = profit from operations / finance costs = £80,000 / £10,000 = 8. Gearing ratio = debt / (debt + equity) = £400,000 / £750,000 x 100% = 53%. Debt/equity ratio = debt / equity = £450,000 / £350,000 x 100% = 114%.

Here is an extract from the income statement for Meriden Ltd for the year ended 20X5.


Income statement extract
Year ended 20X5
£’000


Profit from operations
80


Finance costs
10


Profit before tax
70


At the end of the year, Meriden Ltd had total debt of £400,000 and total equity of £350,000.
Calculate the following performance indicators for the year, rounding to the nearest whole number:



Year ended 20X5
£’000


Interest cover



Gearing ratio (%)



Debt/equity ratio (%)

Rachetman

The debt to equity ratio is the one you've got wrong; the other two are correct. You've put the debt at £450k, instead of £400k.

zaf1987

Sorry Rachetman thats the official answer i havent put my answer on their. also its the how its calculated that i need clarified i was under impression 2 ways of calculating gearing total debt/total equity c 100, and debt / (debt + equity). i used the first which gives 114% and not 53%.

Rachetman

I should clarify - for the debt to equity ratio, the correct answer is 114% [(£400k/£350k) x 100%]. And I'm sure the answer you gave for the gearing ratio (53%) is correct. I don't believe there is another way to calculating both gearing and DTE.

CeeJaySix

Zaf,

I wrote a full explanation of the ratios which I have just realised is irrelevant to you as you seem to have them correct. I've left it below in case it helps anyone else.

I don't understand your question - the correct answer is 114% (400k / 350k), which is also the model answer (although the answer contains 450k, the calculation is definitely done with 400k). You say you have used this formula and got 114%, which agrees to the model answer. Is it simply that the green light has marked it wrong despite you entering the correct answer? This seems to be a common problem, and may be worth adding to this thread: http://forums.aat.org.uk/forum/for-e...en-light-tests. I assume your correct gearing ratio answer was the 53%?

If I'm missing something please ask again!

Gearing ratios explained, for anyone who's interested:

Gearing ratios can be a bit funny, they can be calculated in a number of ways depending on what you want the ratio to show. I seem to remember SandyHood wrote an excellent post on the subject a while ago, you might be able to turn it up with a bit of searching.

That aside, there are two gearing ratios you need to know for AAT, and you have the formulae for both correct. 'Debt' means long-term finance, usually loans and preference shares. 'Equity' is share capital plus reserves (for AAT purposes).

The first AAT call the 'gearing ratio', and is used to show the proportion of total funding of the business comes from sources on which finance costs must be paid. This is debt/(equity plus debt).

The second is know as the 'gearing (debt to equity) ratio' and is used to show, funnily enough, the ratio of debt to equity, or funding on which finance costs must be paid against funding on which there are no finance costs. This is simply debt/equity.

Clearly these two formulae are different and will give different answers - the second will always give a higher %age, and for both the higher the answer the riskier the finance structure of the business.