Week 23 - Measures of Return on Investment and Risk Pt2 Flashcards
(16 cards)
Debt-Equity ratio
E.g. J Sainsbury plc 2020
* Non-Current Liabilities: £8,117m
* Equity Share Capital and Reserves: £7,277m
8,117mil/ 7,277mil x100 = 111%
- Interpretation
- Sainsbury debt is 111% of its equity.
Which company is more highly leveraged and why is that riskier?
Tesco is more highly leveraged because it has a higher debt-to-equity ratio. Higher leverage means greater financial risk, as the company must meet interest obligations even when profits are low.
What is the gearing ratio formula?
Gearing ratio = Debt capital/ (Debt capital + Equity Capital) x100
= X%
What it shows: The proportion of a company’s capital that comes from debt.
Importance: Helps assess financial risk; higher gearing means more debt relative to equity.
Gearing ratio
E.g. J Sainsbury plc 2020
* Non-Current Liabilities: £8,117m
* Equity Share Capital and Reserves: £7,277m
8117mil/ (8117mil+7277mil) x100 = 53%
- Interpretation:
- Sainsbury debt makes up 53% of total capital.
Which company is more highly leveraged and riskier?
Gearing ratio shows the relative proportion of debt to equity.
Higher leverage (more debt) increases risk, as interest payments must be made regardless of profitability.
Tesco has a higher gearing ratio (more debt), making it more highly leveraged and riskier compared to its competitors.
What is gearing in the context of finance?
Gearing involves using debt financing, which can provide benefits like a tax shield from interest payments and an equity multiplier, potentially leading to higher ROE.
What is the downside of high gearing?
High gearing increases financial risk (difficulty paying interest) and leads to more profit volatility for shareholders.
What is financial risk?
Financial risk refers to exposure to fixed interest payments and the risk of not being able to meet these payments.
What is operating risk?
Operating risk refers to risks related to the industry in which the company operates, such as volatility in demand and competition.
What happens to profit in a high-geared company when profit before interest increases?
The profit increases proportionately more compared to a low-geared company.
What happens to profit in a high-geared company during bad times?
Profit decreases proportionately more, and the company still must pay interest.
How do shareholders of geared companies perform in good times?
Shareholders do well in good times due to higher returns.
How do shareholders of geared companies perform in bad times?
Shareholders face greater risk, as the company must still pay interest despite lower profits.
What do higher P/E and MTB ratios generally indicate?
They indicate better future expectations of the company or that the company is overvalued.
What indicates a lower risk investment?
Higher P/E, higher interest cover, and lower gearing ratios typically indicate lower risk.
Which company appears to be less risky based on the ratios?
Morrison appears to be less risky because it has the highest interest cover and the lowest debt levels.
