TABLE OF CONTENTS In this chapter you will be learning more about how to interpret financial statements. We will be continuing our review of LMN plc, looking first at the company's financial structure and then at its performance from the point of view of shareholders and potential shareholders. We will also be interpreting the cash flow statement.
There are two important ratios which help in analysing a company's financial structure.
The gearing ratio
The interest cover ratio
Gearing refers to the proportion of a company's funds that are provided by borrowings on which interest is payable regardless of how well the company performs.
If a company has a large amount of loan capital compared to shareholders equity, it is said to be high geared.
If a company has a small amount of loan capital compared to shareholders equity, it is said to be low geared.
Gearing has important implications for management because if the company is high geared it means that managers must react quickly if revenues start to fall. Shareholders will also be interested in the level of gearing, because any changes in revenue could have a dramatic effect on their fortunes if the company is high geared.
The following example will demonstrate why this happens.
Two companies, High Gear Limited and Low Gear Limited, each have the same amount of capital in total, but different proportions of share capital and loan capital as follows:
