Topic list Syllabus reference

Alpha Co	Brava Co
Charlie Co
	$000	$000	$000
Ordinary shares	600	400	300
Retained earnings	200	200	200
Revaluation surplus	100	100	100
	900	700	600
6% preference shares (redeemable)	—	—	100
10% loan stock	100	300	300
Capital employed	1,000	1,000	1,000
Gearing ratio	10%	30%	40%
Equity to assets ratio	90%	70%	60%

Now suppose that each company makes a profit before interest and tax of $50,000, and the rate of tax on company profits is 30%. Amounts available for distribution to equity shareholders will be as follows.

	Alpha Co	Brava Co	Charlie Co
	$000	$'000	$000
Profit before interest and tax	50	50	50
Interest/preference dividend	10	30	36
Taxable profit	40	20	14
Taxation at 30%	12	6	4
Profit for the year	28	14	10

If in the subsequent year profit before interest and tax falls to $40,000, the amounts available to ordinary

shareholders will become as follows.	Д/рЛа Co $'000	Brava Co $'000	Charlie Co $000
Profit before interest and tax	40	40	40
Interest/preference dividend	10	30	36
Taxable profit	30	10	4
Taxation at 30%	9	3	1
Profit for the year	21	7	3
Note the following:
Gearing ratio	10%	30%	40%
Equity to assets ratio	90%	70%	60%
Change in PBIT	-20%	-20%	-20%
Change in profit available for ordinary shareholders	-25%	-50%	-70%

The more highly geared the company, the greater the risk that little (if anything) will be available to distribute by way of dividend to the ordinary shareholders. The example clearly displays this fact in so far as the more highly geared the company, the greater the percentage change in profit available for ordinary shareholders for any given percentage change in profit before interest and tax. The relationship similarly holds when profits increase, and if PBIT had risen by 20% rather than fallen, you would find that once again the largest percentage change in profit available for ordinary shareholders (this means an increase) will be for the highly geared company. This means that there will be greater volatility of amounts available for ordinary shareholders, and presumably therefore greater volatility in dividends paid to those shareholders, where a company is highly geared. That is the risk: you may do extremely well or extremely badly without a particularly large movement in the PBIT of the company.
The risk of a company's ability to remain in business was referred to earlier. Gearing or leverage is relevant to this. A highly geared company has a large amount of interest to pay annually (assuming that the debt is external borrowing rather than preference shares). If those borrowings are 'secured' in any way (and loan notes in particular are secured), then the holders of the debt are perfectly entitled to force the company to realise assets to pay their interest if funds are not available from other sources. Clearly the more highly geared a company the more likely this is to occur when and if profits fall.

5. 
   Interest cover
   

Formula to learn
The interest cover ratio shows whether a company is earning enough profits before interest and tax to pay its interest costs comfortably, or whether its interest costs are high in relation to the size of its profits, so that a fall in PBIT would then have a significant effect on profits available for ordinary shareholders.
, , , Profit before interest and tax
Interest cover =
Interest charges
An interest cover of two times or less would be low, and should really exceed three times before the company's interest costs are to be considered within acceptable limits.
Returning first to the example of Alpha Co, Brava Co and Charlie Co, the interest cover was:

	Alpha Co	Brava Co	Charlie Co
(a) When PBIT was $50,000 =	$50,000	$50,000	$50,000
	$10,000	$30,000	$36,000
	5 times	1.67 times	1.39 times
(b) When PBIT was $40,000 =	$40,000	$40,000	$40,000
	$10,000	$30,000	$36,000
	4 times	1.33 times	1.11 times

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Both Brava Co and Charlie Co have a low interest cover, which is a warning to ordinary shareholders that their profits are highly vulnerable, in percentage terms, to even small changes in PBIT.


Interest cover
Question
Returning to the example of Furlong Co in Paragraph 1.2, what is the company's interest cover?
Answer







Interest payments should be taken gross, from the note to the accounts, and not net of interest receipts as shown in the statement of profit or loss. 20X8 360,245 18,115

PBIT

Interest payable

20X7
247,011
21,909

= 20 times

= 11 times

Furlong Co has more than sufficient interest cover. In view of the company’s low gearing, this is not too surprising and so we finally obtain a picture of Furlong Co as a company that does not seem to have a debt problem, in spite of its high (although declining) debt ratio.

6. 
   Cash flow ratio
   

The cash flow ratio is the ratio of a company's net cash inflow to its total debts.

1. 
   Net cash inflow is the amount of cash which the company has coming into the business from its operations. A suitable figure for net cash inflow can be obtained from the statement of cash flows.
   
2. 
   Total debts are short-term and long-term payables, including provisions. A distinction can be made between debts payable within one year and other debts and provisions.
   

Obviously, a company needs to be earning enough cash from operations to be able to meet its foreseeable debts and future commitments, and the cash flow ratio, and changes in the cash flow ratio from one year to the next, provide a useful indicator of a company's cash position.

7. 
   Short-term solvency and liquidity
   

Key term
Profitability is of course an important aspect of a company's performance and gearing or leverage is another. Neither, however, addresses directly the key issue of liquidity.
Liquidity is the amount of cash a company can put its hands on quickly to settle its debts (and possibly to meet other unforeseen demands for cash payments too).
Liquid funds consist of:

1. 
   Cash
   
2. 
   Short-term investments for which there is a ready market
   
3. 
   Fixed-term deposits with a bank or other financial institution, for example, a six month high-interest deposit with a bank
   
4. 
   Trade receivables (because they will pay what they owe within a reasonably short period of time)
   
5. 
   Bills of exchange receivable (because like ordinary trade receivables, these represent amounts of cash due to be received within a relatively short period of time)
   

In summary, liquid assets are current asset items that will or could soon be converted into cash, and cash itself. Two common definitions of liquid assets are:

• 
  All current assets without exception
  
• 
  All current assets with the exception of inventories
  

A company can obtain liquid assets from sources other than sales of goods and services, such as the issue of shares for cash, a new loan or the sale of non-current assets. But a company cannot rely on these at all times, and in general, obtaining liquid funds depends on making sales revenue and profits. Even so, profits do not always lead to increases in liquidity. This is mainly because funds generated from trading may be immediately invested in non-current assets or paid out as dividends.
The reason why a company needs liquid assets is so that it can meet its debts when they fall due. Payments are continually made for operating expenses and other costs, and so there is a cash cycle from trading activities of cash coming in from sales and cash going out for expenses.

8. 
   The cash cycle
   

To help you to understand liquidity ratios, it is useful to begin with a brief explanation of the cash cycle.
The cash cycle describes the flow of cash out of a business and back into it again as a result of normal trading operations.
Cash goes out to pay for supplies, wages and salaries and other expenses, although payments can be delayed by taking some credit. A business might hold inventory for a while and then sell it. Cash will come back into the business from the sales, although customers might delay payment by themselves taking some credit.
The main points about the cash cycle are:

1. 
   The timing of cash flows in and out of a business does not coincide with the time when sales and costs of sales occur. Cash flows out can be postponed by taking credit. Cash flows in can be delayed by having receivables.
   
2. 
   The time between making a purchase and making a sale also affects cash flows. If inventories are held for a long time, the delay between the cash payment for inventory and cash receipts from selling it will also be a long one.
   
3. 
   Holding inventories and having receivables can therefore be seen as two reasons why cash receipts are delayed. Another way of saying this is that if a company invests in working capital, its cash position will show a corresponding decrease.
   
4. 
   Similarly, taking credit from creditors can be seen as a reason why cash payments are delayed.
   

The company's liquidity position will worsen when it has to pay the suppliers, unless it can get more cash in from sales and receivables in the meantime.
The liquidity ratios and working capital turnover ratios are used to test a company's liquidity, length of cash cycle, and investment in working capital. The cash cycle is also referred to as the operating cycle. There is a question on this following Section 3.14.

9. 
   Liquidity ratios: current ratio and quick ratio
   

The 'standard' test of liquidity is the current ratio. It can be obtained from the statement of financial position.


_ . .. Current assets