Topic list Syllabus reference

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3 Liquidity, gearing/leverage and working capital
Banks and other lenders will be interested in a company’s gearing level.

1. 
   Long-term solvency: debt and gearing ratios
   

Debt ratios are concerned with how much the company owes in relation to its size, whether it is getting into heavier debt or improving its situation, and whether its debt burden seems heavy or light.

1. 
   When a company is heavily in debt, banks and other potential lenders may be unwilling to advance further funds.
   
2. 
   When a company is earning only a modest profit before interest and tax, and has a heavy debt burden, there will be very little profit left over for shareholders after the interest charges have been paid. And so if interest rates were to go up (on bank overdrafts and so on) or the company were to borrow even more, it might soon be incurring interest charges in excess of PBIT. This might eventually lead to the liquidation of the company.
   

These are two big reasons why companies should keep their debt burden under control. There are four ratios that are particularly worth looking at, the debt ratio, gearing ratio, interest cover and cash flow ratio.

2. 
   Debt ratio
   

Formula to learn
The debt ratio is the ratio of a company's total debts to its total assets.

1. 
   Assets consist of non-current assets at their carrying amount, plus current assets
   
2. 
   
   Debts consist of all payables, whether they are due within one year or after more than one year You can ignore other non-current liabilities, such as deferred taxation.
   

There is no absolute guide to the maximum safe debt ratio, but as a very general guide, you might regard 50% as a safe limit to debt. In practice, many companies operate successfully with a higher debt ratio than this, but 50% is nonetheless a helpful benchmark. In addition, if the debt ratio is over 50% and getting worse, the company's debt position will be worth looking at more carefully.
In the case of Furlong the debt ratio is:
20X8 20X7
Total debts $ (860,731 + 100,000) $ (895,656^00,000)