Gearing, Cover

This panel of figures gives an insight into the structure of a company's balance sheet. In particular, the overall level of borrowings (gross gearing), how much is short and long-term, borrowings less cash (net gearing), short-term liquidity and the cash position (if any). Other useful statistics include the extent to which interest payments are covered by profits and dividends by earnings.

The first column of figures, headed Incl, shows the percentage of net gearing, cash, gross gearing and one- and five-year gearing in relation to shareholders' funds (share capital plus reserves, less preference capital redeemable within 12 months). The second column, headed Excl, is a much harsher measure, as all intangibles, such as brand names, copyrights and goodwill, have been excluded from shareholders' funds.

Net gearing is expressed as the percentage of total borrowings (less cash) to shareholders' funds (less intangibles). Aminus figure indicates nil net gearing and denotes a net cash position, which is also expressed as a percentage of shareholders' funds less intangibles.

The cash percentage figures also include near cash assets such as treasury bills and certificates of deposit. Marketable securities are not included in near cash. This is a harsh measure which assumes that they may be difficult to realise in an emergency.

There are several reasons why investors should be particularly aware of the perils of high gearing:-

1. Any company with high gearing, which includes bank and other short-term borrowings, is likely to be very sensitive to changes in interest rates.
2. A highly-geared company can be very vulnerable, and can fail completely, during a liquidity crisis, especially if most if its borrowings are short-term. There is no substitute for cash in the bank when a gale is blowing through world financial markets.
3. The results of highly-geared companies tend to exaggerate the underlying trend. All shareholders' funds are invested, and further substantial borrowings result in the company being full committed and therefore subject to prevailing winds. When businesses are recovering, high gearing can be a massive advantage for shareholders, but the reverse is also the case in tougher times.

It is difficult to set a firm guideline for gearing. Much depends on whether a company's borrowings are short or long-term, on the outlook for its industry and the efficiency of its management. Generally speaking, net gearing of over 50% calls for more detailed investigation. This is especially the case if a large proportion of the overall borrowings are short-term.

A company with a high dividend yield, low dividend cover and high gearing is often on the brink of trouble.

Quick Ratio
The quick ratio is an attempt to indicate what would happen if a company suddenly had to pay off all its current liabilities. For this reason, only assets that can be readily turned into cash are included and stock and work-in-progress is excluded.

The basic formula is therefore:

Generally speaking, I like to see a quick ratio of over one, but many retailing operations can manage on much less, as they can sell their products several weeks before paying their suppliers.

Current Ratio

This ratio is determined by dividing the current assets of a business by its current liabilities. The resultant ratio shows the number of times current liabilities are covered by current assets. The basic formula is therefore:

A high ratio (2 or more) is usually a sign of financial strength and a low ratio (1.25 or less) can be a sign of financial weakness.

Also, the year by year trend of current ratios can alert investors to fundamental changes in a business's financial structure. Retailing companies usually have small debtors, as most of their sales are paid for in cash; therefore, they usually have lower than average current ratios. In other industries, large current ratios can sometimes result from excessive stocks or poor control of debtors.

Interest Cover

This ratio is calculated by taking a company's normalised historic profits before interest and taxation and dividing them by the annual interest charge. The resultant figure indicates the company's capacity to continue paying interest on its borrowings out of annual profits.

The basic formula is therefore:

Low and/or deteriorating interest cover is an obvious danger signal and can sometimes be a precursor to reconstruction, fund-raising or business failure.