ACCA MA Syllabus F. Performance Measurement - Measuring Risk - Notes 5 / 13
Measurement of Risk
Measurement of risk considers the financial risk incurred by borrowing.
Gearing
Capital gearing is concerned with the amount of debt in a company’s long-term capital structure. It provides a long-term measure of liquidity. It can be calculated as:-
Long-Term Debt x 100%
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Long-term Debt + EquityIf the firm has excessive debt, then the need to pay interest before dividends will increase the risks faced by shareholders if profits fall.
Interest Cover
Interest cover is expressed as:
Profit before interest and tax = Number of times
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Interest paidThis ratio represents the number of times that interest could be paid out of profit before interest and tax.
Illustration
Long term liabilities $20,000
Shareholders funds and reserves $30,000
Operating profit (PBIT) $5,000
Finance cost $1,000
What is the capital gearing ratio?
20,000/(20,000+30,000) * 100% = 40%
What is the interest cover ratio?
5,000/1,000 = 5 times