3 Accounts and finance

Table of Contents

1. Topic pack - Accounts and finance - introduction
2. 3.1 Sources of finance - notes
3. 3.1 Sources of finance - questions
4. 3.2 Investment appraisal - notes
5. Investment appraisal
6. 3.2 Investment appraisal - questions
7. 3.3 Working capital - notes
8. 3.3 Working capital - questions
9. 3.4 Budgeting - notes (HL only)
10. 3.4 Budgeting - questions
11. 3.5 Final accounts - notes
12. 3.5 Final accounts - questions
13. 3.5 Final accounts - simulations and activities
14. 3.6 Ratio analysis - notes
    1. Ratio analysis
    2. Profitability ratios
    3. Interpretation of profitability ratios
    4. Profitability - examples
    5. Liquidity ratios - introduction
    6. Current ratio
    7. Acid test ratio
    8. Efficiency ratios
    9. Efficiency ratios - ROCE
    10. Efficiency ratios - asset turnover ratio
    11. Efficiency ratios - stock turnover ratio
    12. Debtor days
    13. Creditor days
    14. Efficiency ratios - use and calculation
    15. Financial efficiency ratios - examples
    16. Shareholders' ratios
    17. Factors affecting share prices
    18. Gearing
    19. Ratio analysis - A summary
15. 3.6 Ratio analysis - questions
16. 3.6 Ratio analysis - simulations and activities
17. Printable version

Gearing AO2, AO4

AO2 You need to be able to: Demonstrate application and analysis of knowledge and understanding Command Terms: These terms require students to use their knowledge and skills to break down ideas into simpler parts and to see how the parts relate: Analyse, Apply, Comment, Demonstrate, Distinguish, Explain, Interpret, Suggest

AO4 You need to be able to Demonstrate a variety of appropriate skills. Command Terms These terms require you to demonstrate the selection and use of subject-specific skills and techniques: Annotate, Calculate, Complete, Construct, Determine, Draw, Identify, Label, Plot, Prepare

Once businesses are operating they have two main sources of money for investment to grow the firm:

• Loan capital from banks, and other institutions (Debt)
• Share capital and reserves, including retained profit (Equity)

Most firms operate using a mixture of borrowed capital and their own finance. There are advantages and disadvantages to both sources.

Share capital and retained profits are free of fixed charges; only dividends need to be paid. However, this form of capital may be limited. Relying on it alone may slow growth.

Loans, however, cost a company money in interest payments, but a lack of loans can stifle growth.

The balance between loans and share capital is important. This leads to the concept of the gearing of a business.

Which develops further into the gearing ratio.

Gearing ratio

This is sometimes known as the debt equity ratio.

where capital employed = loan capital (or long-term liabilities)+ share capital+retained profit (IB Syllabus)

What is loan capital? All monies that have been borrowed and interest has to be paid. It will include long-term bank loans, debentures, overdrafts etc. It does not include debtors or creditors; they are interest free.

The gearing ratio value can vary between 0 and 100%. What do individual results mean?

A firm is said to be highly geared if the gearing ratio is over 50%; in other words loans represent more than 50% of capital employed. The higher the gearing ratio: the higher the degree of risk. A lower geared company offers a lower risk investment and as a result they can normally negotiate additional loans more easily and at a lower interest rate than highly geared company.

Improving the ratio AO3

AO3 You need to be able to: Demonstrate synthesis and evaluation. Command terms these terms require you to rearrange component ideas into a new whole and make judgments based on evidence or a set of criteria. Compare,  Compare and contrast, Contrast, Discuss, Evaluate, Examine, Justify, Recommend, To what extent

Remember, gearing is a symptom: so changing it in its own right has little value. Obviously, its improvement will depend whether it is currently too high or too low.

Too low: The firm could borrow more money provided there is a suitable investment. Is the real problem behind the low gearing ratio a lack of research or product ideas?

Too high: the firm should attempt to pay off some loans, or raise more share capital. Perhaps the firm is trying to expand too fast.

The gearing ratio of a business will change with time, usually on a regular cyclical basis. It will grow as it invests to expand, and then fall as the retained profits increase as a result of the growth. It will then grow again as the process is repeated with new products etc.

Sources of finance

Sources of finance for a firm will be of one of two types, those that change gearing and those that do not. Some sources will increase gearing; others will reduce it.

1. Methods that change gearing

a) Those that increase gearing:

• Bank loans - Short- or long-term loans from banks. Interest is paid, but the bank has no say in the running of the firm (unless they buy shares, or manage to get a director on the board).
• Commercial paper - a special form of loan where bonds or debentures are bought by specialist financial firms.
• Debentures - a loan instrument.

b) Those that decrease gearing:

• Sale of shares, sometimes at a premium. This will increase shareholders funds. However, the number of shares available to be sold is limited by the regulations of the company which set out its 'authorised share capital'.
• Rights issues. This is where existing shareholders are given the 'right' to buy new shares at a 'special' price.

2. Methods that do not change gearing

• Leasing - the firm does not own the asset; they just rent it. No capital involved, so the balance sheet is unchanged. Costs increase, so profits will fall on the P&L account.
• Sale and leaseback - here the firm sells an asset, and so release cash or capital. The firm leases the asset back, at a cost to the P&L account, but now have the capital to invest in other opportunities.

• Debt factoring - this is a short term, one off operation. Instead of waiting for debtors to pay, as per their purchasing contract, the firm sells sell the debt to a factor company, which pays the firm a proportion of the debt in advance. The remainder of the debt is kept as their fee for providing the service and taking the risk of the debt 'going bad'. In many ways it can be considered a sign of weakness, not strength.

Notice that when a business raises more finance, how it achieves this increase will change its gearing. Remember the following:

• Loan capital can be expensive. Interest has to be paid regardless of the market or profit. Repayments have to be made. Eventually, though, when the loan is repaid the firm still has the asset and is now much more profitable. The lender is not an owner, however, so has no say in the running of the business.
• Share capital never has to be repaid and dividends are paid only when there is a profit. Shareholders are owners, however, so sales of additional shares may result in a loss of control over the business.

The implications for gearing must be considered when deciding how to finance an expansion.

Limitations of gearing

As always a series of ratios is required to analyse the situation of the firm fully, plus knowledge of its history. It is very important to know why the ratio has changed.