Annual reports and financial statements

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MODULE 7 UNIT 2 Video Transcript

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Module 7 Unit 2 Video Transcript KHAMID IRGASHEV: Hello, everyone. Take a moment to think of any kind of business. All businesses have to raise capital to pursue its activities, and to maintain and grow its infrastructure. The capital structure of a business is referred as “gearing”. Gearing is the proportion of capital that is provided by taking out loans, versus the proportion of capital provided by the owner or shareholders of a business.

The formula for calculating the company’s gearing ratio is as follows: Long-term liabilities divided by capital employed multiplied by hundred.

Long-term liabilities include loans that aren’t due within the next year, and mortgages. Capital employed includes share capital, retained earnings, and long-term liabilities.

Look at the following extract from the statement of financial position of a business. The first figure you need is long-term liabilities. You will get this from the liabilities sections of the statement. Be careful not to use the current liabilities figure.

Next, you will need amounts for share capital and retained earnings, which you will find under the owner’s equity section. Remember to add the amounts for long-term liabilities to these amounts to get the capital employed figure.

Now that you have the correct amounts, you will calculate the gearing ratio by dividing 110,000 by the sum of 100,000, 50,000, and 110,000 pounds. This will give you an answer of 0.42, which you will multiply by hundred to get a percentage of 42%.

Businesses are usually regarded as “highly geared” if they have a gearing ratio of more than 50%. If the gearing ratio is less than 25%, business is regarded as having a “low gearing”. A ratio between 25 to 50% is considered normal for most well-established businesses. The gearing of the business in our example is therefore regarded as normal.

The higher the business is geared, more at risk the business will be. This is because the business has an obligation to repay loans at certain times, while it can decide whether or not to pay out profits to the shareholders in the form of dividends. Despite this, loans are usually a more attractive option, as banks often require a lower return on investment than shareholders do. Interest payments are also usually deductible from the tax, unlike dividend payments.

So, what is the best gearing ratio for a business to have? It depends on whether business has enough cash available with which to pay off its debts. A business that has been running for many years and has a reliable cash flow is able to deal with a higher level of gearing than a business that has experiences in unpredictable cash flow.

In this video, you saw that the gearing ratio is used to determine whether or not a business has too much debt relative to the capital invested by its shareholders. Newer business ventures are usually better off making use of owner’s capital, as it doesn’t have to be repaid by a certain time. More established businesses can be highly geared, as they usually have the cash flow available with which to pay off loans.

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You now know that a business has a choice whether to raise capital by getting a loan, or by issuing shares. Although raising capital by issuing shares has its advantages, what do you think are some of the disadvantages to the business of raising share capital rather than taking out a loan?

If you would like to revisit any of the concepts covered in this video, please select the appropriate chapter.

MODULE 7 UNIT 2

Video Transcript

Module 7 Unit 2 Video Transcript