ACCA F9 Financial Management - 2010 - Study text

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Paper F9

Financial management

CHAPTER

Capital structure

Contents

1 Financialgearing

2 Operationalgearing

3 Gearing,riskandreturn

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Financial gearing

 The nature of gearing

 Definition of financial gearing

 The significance of financial gearing

 Income gearing or interest gearing

1 Financial gearing

1.1 The nature of gearing

The UK term ‘gearing’ and the US term ‘leverage’ mean the same thing. They both

refer to the fact that a small change in one item can lead to a much bigger change in

something else. The term ‘gearing’ is derived from the mechanics of the motor car

and the way in which a movement in a small gear wheel makes a much bigger

movement in a larger gear wheel. The term ‘leverage’ is derived from the idea that a

small amount of pressure at one end of a lever can move a much larger item at the

other end of the lever.

In financial analysis, there are two types of gearing.

 Financial gearing, which is concerned with the way in which a small change in

profits before interest and tax can result in larger proportional changes in

earnings (profits after tax).

 Operational gearing is concerned with the way in which a small change in sales

revenue results in a much greater proportional change in operating profits

(profits before interest and tax).

1.2 Definition of financial gearing

The long-term capital of a company can be categorised as either equity capital or

debt capital. Financial gearing measures the extent to which a company is financed

by debt capital.

There are several ways of measuring the financial gearing ratio. Unless you are

given an instruction or a strong hint to do something else in the examination, you

should measure a financial gearing ratio as follows:

Either (A)

Debt capital

Equity capital

× 100%

Or (B)

Debt capital

Equity capital + Debt capital

Chapter 14: Capital structure

Using definition (A), a company is said to be high-geared when debt capital exceeds

equity capital, therefore the ratio exceeds 100%. With definition (B), high gearing is

indicated by a ratio above 50%.

An all-equity company has a financial gearing ratio of 0%.

Gearing can be measured either by:

 Value sin the statement of financial position (balance sheet values), in which case

equity is the total of equity share capital plus reserves, or

 current market values of equity and debt capital (with variable interest debt such

as bank loans valued at their face value and bonds valued at their current

market price).

For financial management purposes, capital gearing should normally be calculated

using market values, not book values (‘balance sheet values’). However if an

examination question gives you information about values in the statement of

financial position (balance sheet values), you should be prepared to calculate and

comment on financial gearing using the ‘balance sheet values’ provided.

Example

Company X has 1 million $1 ordinary shares with a current market price of $3 each.

It is also financed by $1million of 5% bonds with a current market value of 102.00

and $500,000 of bank loans.

What is the company’s financial gearing?

Answer

MV of equity = 1 million shares × $3 = $3 million

MV of debt = $1 million × (1.02) + $500,000 = $1,520,000

Gearing = $1,520,000m/($3 million + $1,520,000) = 33.6%.

1.3 The significance of financial gearing

If the level of financial gearing is high, the company might have difficulties in

meeting its obligations to pay interest and repay the debt capital on time. High

gearing can therefore be risky, and a company should avoid excessive debt and

gearing above a level that it can comfortably afford.

Another feature of financial gearing is that with higher-geared companies, the

earnings per share change rises or falls by a much larger percentage amount, in

response to increases or falls in operating profit (profit before interest and tax). The

following example illustrates this point.

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Example

Two companies Entity A and Entity B are identical in every respect, with the

exception of their capital structure. Both Entities have assets of $1,000,000, and both

have annual profits before interest and tax of $100,000. However, Entity A is an all

equity company, with 1,000,000 shares of $1, and Entity B is a 50%-geared company,

with 500,000 shares of $1 and $500,000 of 8% debt. The rate of taxation is 30%.

The earnings per share (EPS) of each company is calculated as follows:

 EntityA EntityB

 $ $

Beforeinterestandtax 100,000 100,000

Interest 0 ($500,000×8%) 40,000

Profitbeforetaxation 100,000 60,000

Taxation(30%) 30,000 18,000

Profitaftertax 70,000 42,000



Numberofshares 1,000,000 500,000

EPS $0.07 $0.084

Now suppose that the profits before interest and tax increase by 50% to $150,000.

The change in EPS will be as follows.

 EntityA EntityB

 $ $

Beforeinterestandtax 150,000 150,000

Interest 0 ($500,000×8%) 40,000

Profitbeforetaxation 150,000 110,000

Taxation(30%) 45,000 33,000

Profitaftertax 105,000 77,000



Numberofshares 1,000,000 500,000

EPS $0.105 $0.154

IncreaseinEPS 50% 83.3%

The percentage change in the EPS in the geared company is greater than the

percentage change in EPS in the ungeared company.

This rule applies to financial gearing generally. When a company has some debt

capital (i.e. has some gearing), a percentage change in profits before interest and tax

results in a larger percentage change in EPS. The higher the gearing, the greater the

percentage change in EPS will be.

1.4 Income gearing or interest gearing

Financial gearing is a ratio comparing the value of debt and the value of total capital

or the value of equity.

Chapter 14: Capital structure

Income gearing, also called interest gearing, measures annual interest charges as a

percentage of profits before interest and tax. It therefore shows what percentage of

profits available to cover interest payments are actually needed to make the interest

payments.

A ratio of 33% or more would probably be considered very high.

Example

A company made profits before interest and tax of $800,000. It has $5 million of 6%

debt.

The income gearing ratio, or interest gearing ratio, is

$5 million × 6%

$800,000

× 100% = 0.375 or 37.5%

This ratio is high, indicating that the company might have too much debt finance for

the amount of profits that it is earning.

1.5 Interest cover ratio

The income gearing or interest gearing ratio is the inverse of the interest cover ratio.

This ratio measures: profits before interest and tax/interest charges.

Interest cover ratio =

Profit before interest and tax

Interest costs

As a general guide, an interest cover ratio of less than 3.0 is usually considered very

low and ‘risky’. In the example above, the interest cover ratio is:

$800,000

$300,000

= 2.66 times

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Operational gearing

 Definition of operational gearing

 The significance of operational gearing

 Financial gearing and operational gearing

2 Operational gearing

2.1 Definition of operational gearing

Financial gearing considers the capital structure and the ratio debt capital to equity

capital. Operational gearing considers the cost structure of a business operation, and

the ratio of fixed costs to variable costs.

Operational (also called operating) gearing is measured in either of two ways.

Either

Fixed costs

Variable costs

% change in profits before interest and tax

% change in sales revenue

2.2 Significance of operational gearing

Operational gearing is high when fixed costs are high in relation to variable costs.

When operational gearing is high, a given percentage change in sales will result in a

much greater change in profits before interest and tax (operating profits) than when

operational gearing is low.

Example

Two companies, Entity X and Entity Y, both have annual sales of $1,000,000 and

annual operating profits before interest of $500,000. However, their cost structures

are different, as follows:

 EntityX EntityY

 $ $

Sales 1,000,000 1,000,000

Variablecosts 400,000 100,000

Fixedcosts 100,000 400,000

Totalcosts 500,000 500,000

Profit 500,000 500,000

Operationalgearing 0.25 4.00

Chapter 14: Capital structure

Here, operational gearing is measured as the ratio of fixed costs to variable costs.

Now suppose that annual sales increase by 50% to $1,500,000. The operating profit

will now be as follows:

 EntityX EntityY

 $ $

Sales 1,500,000 1,500,000



Variablecosts 600,000 150,000

Fixedcosts 100,000 400,000

Totalcosts 700,000 550,000



Profit 800,000 950,000



Operationalgearing 0.167 2.67

For Entity X, a 50% increase in sales has resulted in a 60% increase in earnings

before interest and tax, from $500,000 to $800,000. The operational gearing of Entity

X could therefore be measured as:

60%

50%

= 1.20

For Entity Y, which has much higher operational gearing a 50% increase in sales has

resulted in a 90% increase in earnings before interest and tax, from $500,000 to

$950,000.

The operational gearing of Entity Y could therefore be measured as:

95%

50%

= 1.90

The greater the operating gearing:

 the greater the variability in profits as a result of a change in sales, and so

 the greater the variability in the returns to the shareholders and

 in all probability, the greater the variability in the share price.

2.3 Financial gearing and operational gearing

With high financial gearing, a percentage change in profits before interest and tax

results in a greater percentage change in earnings per share. With high operational

gearing, a percentage change in sales results in a greater percentage change in

profits before interest and tax.

If a company has high operational gearing and high financial gearing, its earnings

per share will therefore change by a much greater percentage amount for any given

percentage change in annual sales. A company with volatile annual earnings is a

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high-risk company, and its annual EPS could fluctuate sharply from one year to the

next.

Exercise 1

Entity Green has $2,000,000 of long-term capital, consisting of 800,000 shares worth

$800,000 and $1,200,000 of 10% debt capital. The company has budgeted annual

sales of $800,000, and its expected total earnings and EPS are as follows:

 $ $

Sales 800,000



Variablecosts 200,000

Fixedcosts 400,000

Totalcosts 600,000



Profitbeforeinterestand

tax

200,000

Interest($1,200,000×10%) 120,000

Profitbeforetax 80,000

Taxat40% 32,000

Earnings 48,000



Numberofshares 800,000 800,000

EPS $0.06

Now suppose that the budgeted sales figure is revised to $1,000,000, an increase of

25%.

Required

(a) Calculate the operational gearing, measured as the ratio of the percentage

increase in profit before interest and tax the percentage increase in sales.

(b) Calculate the financial gearing, measured as the ratio of the percentage change

in total earnings (or EPS) to the percentage increase in profit before interest

and tax.

in total earnings (or EPS) to the percentage increase in sales.

(d) Confirm that your answer in (c) is your answer in (a) multiplied by your

answer in (b).

You can use the table above to write your answer.

This exercise should illustrate the great volatility in earnings of a company with

high operational gearing and high financial gearing.

Chapter 14: Capital structure

Gearing, risk and return

 Gearing and risk

 Gearing and return

 Gearing and share prices

3 Gearing, risk and return

3.1 Gearing and risk

High gearing is risky for equity investors. Risk can be defined as volatility in EPS. If

an investor buys shares in a company with high operational gearing and high

financial gearing, EPS will be volatile. This means that a relatively small percentage

change in actual sales, above or below the expected or budgeted level, will result in

a much greater percentage change, up or down, in EPS.

Risk-seeking investors might want to invest in such companies, hoping that sales

will be higher than expected, and EPS much higher.

An investor looking for fairly stable and predictable annual EPS will want to avoid

companies with high operational and financial gearing. They would prefer all-

equity companies in which variable costs are a high proportion of total costs.

3.2 Gearing and return

To compensate them for the risk of high volatility in EPS, investors in a high-geared

company will expect a higher return on their investment than investors in a low-

geared company.

For example, suppose that an investor could invest in shares at a cost of $10 per

share, knowing for certain that the annual EPS would be $1 or 10% every year. If the

same investor could invest the same $10 in a company with high operational and

financial gearing, he would want to expect a return in excess of 10% to compensate

him for the higher risk. For example, he might expect a return of 14%. Because of the

high gearing, a fairly small change in annual sales above or below expectation will

result in a much larger change in EPS, and the actual EPS could turn out to be far

more than 14%, but could also be much less.

3.3 Gearing and share prices

Higher gearing is more risky, and investors in high-geared companies will expect a

higher return as compensation for the risk.

Gearing will also affect share prices, because share prices are linked to expected

return.

Paper F9: Financial management

There is a dividend valuation model, which states what the market price of a share

ought to be assuming constant annual dividends into the future. The share price

should be:

MV =

Where:

 MV is the current market price of the share, excluding any dividend currently

receivable

 d is the annual dividend

 r is the shareholders’ required rate of return per year, expressed as a proportion

Higher risk, meaning that shareholders expect a higher return, results in a lower

share price.

Example

Two companies, Company A and Company B, both expect to pay a dividend per

share of $0.60 to their shareholders in every year into the indefinite future.

Company A has low operational and financial gearing, whereas Company B has

high operational and financial gearing.

Shareholders in Company A expect the annual dividend to vary only slightly

around the expected average of $0.60 in perpetuity. Shareholders in Company B are

aware that although the expected average annual dividend to be $0.60, there could

be some large variations above or below this average due to the volatility in

earnings.

Shareholders in Company A expect an annual return on investment of 10% whereas

shareholders in Company B expect an annual return on investment of 15%, to

compensate them for the higher risk.

 The expected share price for Company A will be:

$0.60

0.10

= $6.00

 The expected share price for Company B will be:

$0.60

0.15

= $4.00

For the same annual dividend, shareholders will give a higher value to the lower-

geared, less risky investment, because the ‘cost of equity’ is lower. The important

connection between financial gearing and ‘cost of capital’ is considered in more

detail in later chapters.

ACCA F9 Financial Management - 2010 - Study text - Emile Woolf Publishing

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