How debt and equity decisions affect financial ratios

Businesses often need long-term finance for expansion or investments, and the choice between debt (such as bank loans) and equity (such as issuing new shares) can significantly influence key financial ratios. Debt increases financial risk due to interest payments, while equity dilutes ownership but avoids repayment obligations.

Key external long-term sources of finance

• Debt financing - Involves borrowing, like long-term bank loans, which raises non-current liabilities and increases gearing. High interest rates can make this approach costly and risky.
• Equity financing - Involves selling new shares, which boosts shareholders' equity and reduces gearing.

Effects on gearing and profitability

• Higher debt - Increases gearing, which can amplify returns for shareholders if investments are profitable.
• Higher equity - Lowers gearing.

Calculating and interpreting the gearing ratio

The gearing ratio measures the proportion of a business's capital that comes from debt, helping assess financial risk. A high ratio indicates heavy reliance on borrowing, which can be risky, while a low ratio suggests stability.

$\text{Gearing ratio}=\frac{\text{non-current liabilities}}{\text{capital employed}}\times 100$

Where:

• Non-current liabilities = Long-term debts (£)
• Capital employed = Total long-term finance, including shareholders' equity and non-current liabilities (£)

A gearing ratio above 50% is often considered high, signalling potential vulnerability to interest rate changes or profit fluctuations.

Worked example - Calculating gearing after financing decisions

A technology firm needs £20 million to develop a new software platform. It currently has non-current liabilities of £60 million, capital employed of £150 million, and shareholders' equity of £90 million. Calculate the current gearing ratio, then recalculate if it borrows the full £20 million or raises it through new shares.

Step 1: Identify the values

• Non-current liabilities = £60 million
• Capital employed = £150 million
• Shareholders' equity = £90 million
• Additional finance needed = £20 million

Step 2: Calculate current gearing

$\text{Gearing ratio}=\frac{\pounds 60\text{ million}}{\pounds 150\text{ million}}\times 100=40\%$

Step 3: Calculate gearing if borrowing all £20 million

New non-current liabilities = £60 million + £20 million = £80 million

New capital employed = £150 million + £20 million = £170 million

$\text{Gearing ratio}=\frac{\pounds 80\text{ million}}{\pounds 170\text{ million}}\times 100=47.1\%$

Step 4: Calculate gearing if raising £20 million through shares

New non-current liabilities = £60 million (unchanged)

New capital employed = £150 million + £20 million = £170 million

$\text{Gearing ratio}=\frac{\pounds 60\text{ million}}{\pounds 170\text{ million}}\times 100=35.3\%$

The impact of dividend strategies on ratios

Dividend strategies involve decisions on how much profit to distribute to shareholders as dividends, balancing the need to reward investors with retaining funds for business growth. In public limited companies, shareholders expect regular dividends as a return on their investment.

Factors influencing dividend levels

• Profit after tax - Higher profits allow for larger dividends without straining finances.
• Liquidity - Businesses must maintain enough cash to pay dividends while covering operational needs.
• Share price maintenance - High dividends can support share prices, especially during new share issues.

Effects on key ratios

• Reducing dividends - Can preserve cash but may lower dividend yield and increase the price-to-earnings (P/E) ratio if share prices fall due to investor dissatisfaction.
• Maintaining or increasing dividends - Boosts dividend yield and can stabilise share prices, though it may reduce retained earnings for reinvestment.

Dividend yield formula

The dividend yield formula measures the return from dividends relative to the share price.

$\text{Dividend yield}=\frac{\text{dividend per share}}{\text{market share price}}\times 100$

Where:

• Dividend per share = Total dividends divided by number of shares (£)
• Market share price = Current price per share (£)

Worked example - Assessing dividend strategy impacts

A manufacturing firm has seen profits drop over two years. Its current dividend per share is £0.60, market share price is £15. If earnings per share fall to £1.20 and the dividend is cut to £0.30 (assuming share price stays the same), calculate the current dividend yield, then the new dividend yield and P/E ratio.

Step 1: Identify the values

• Current dividend per share = £0.60
• Market share price = £15
• New earnings per share = £1.20
• New dividend per share = £0.30

Step 2: Calculate current dividend yield

$\text{Dividend yield}=\frac{\pounds 0.60}{\pounds 15}\times 100=4\%$

Step 3: Calculate new dividend yield

$\text{Dividend yield}=\frac{\pounds 0.30}{\pounds 15}\times 100=2\%$

Step 4: Calculate new P/E ratio

$\text{P/E ratio}=\frac{\pounds 15}{\pounds 1.20}=12.5$

How business growth and strategies influence financial ratios

Business growth, whether through expansion, acquisitions, or new strategies, affects ratios by altering costs, profits, and financing. Growth can lead to economies of scale, reducing costs per unit, but may initially strain liquidity and returns.

Impacts of growth on ratios

• Growth rate - Rapid growth can improve return on capital employed (RoCE) through higher sales but may increase gearing if financed by debt.
• Economies of scale - Achieved via acquisitions or larger operations, these lower fixed costs per unit, boosting profit margins.
• Asset management - Selling redundant assets reduces debt from acquisitions, improving liquidity and gearing; factory closures rationalise production, enhancing operating profit margins and RoCE.

Specific business strategies and their effects

Rationalisation:

• Involves cutting unnecessary costs, such as closing inefficient sites.
• This reduces operating expenses and increases operating profit margin and RoCE.

New product development:

• Short term - High research and development (R&D) costs can decrease profits, liquidity, RoCE, and shareholder returns.
• Long term - Successful products increase sales, profit margins, RoCE, liquidity, and returns to shareholders.

Market development:

• Short term - Entry costs (e.g., marketing in new regions) reduce profit margins, RoCE, and liquidity.
• Long term - If effective, it expands customer base, improving profit margins, RoCE, and shareholder returns.

Low price strategy:

• Lowers profit margins unless increased output achieves economies of scale.
• Reducing fixed costs per unit can potentially improve overall profitability.