Capital Structure and Financial Ratios – Financial Gearing – ACCA Financial Management (FM)
Reader Interactions
Comments
Leave a Reply
You must be logged in to post a comment.
Free ACCA & CIMA online courses from OpenTuition
Free Notes, Lectures, Tests and Forums for ACCA and CIMA exams
20% off ACCA & CIMA Books
OpenTuition recommends the new interactive BPP books for December 2024 exams.
Get your discount code >>
Using market value for the gearing ratio.
I understand why someone should want to use the market value of the shares for the ratio – because they better reflect the real value of the company’s assets and the proportion of the shareholders against the debts.
However, I don’t understand why should you use the market value of the debts in the ratio. I think the market value of the debts doesn’t have any effect on the company and its gearing.
(the company will not have to pay more or less if the market value of the debts goes up or down.)
Can you please help me out?
Firstly, the gearing is checking how the company is currently financed. Secondly if they were to repay the debt now then they would have to buy it back on the stock exchange at the current market value and then cancel it. Thirdly it is the current market value that will dictate the cost of raising any future debt. And fourthly is is the current market value of equity plus debt that more realistically values the total assets less currently liabilities of the company.
Oh.
Thank you.
You are welcome 🙂
how do i access the notes
Click on ‘ACCA’ in the top bar. Then choose ‘FM’. That will take you to a page with links to all of our free resources for Paper FM.
Hello Mr John.
When calculating financial gearing, do we include any overdraft or short term loan as part of debt borrowing?
Or is it simply long term debt borrowing?
Thank you!
Just long-term borrowing. (We would only include overdraft borrowing if it was intended to be for the long-term).
Thank you so much sir! 🙂
You are welcome 🙂
Hello Sir, so does it mean to get the market value for debt we multiply the book value with the interest yield?
No. You need to watch my free lectures on the valuation of securities.
Dear Sir,
I have a query that, as we know Company wants to see their shares being traded more & more than of their book/par values so that Shareholder’s wealth maximizes, But what about Tradeable Debts? Do Company wanna see their Market price being more than its Book/par value? higher Market price of Debt means low Cost of Debt for the company hence increase in Firm value BUT on the other hand increase in Gearing & Financial risks too…so what’s the preferred choice for companies here?
They will not have a preferred choice, for two reasons.
One reason is that the directors are working for the shareholders, not for the lenders.
The other, more important, reason is that the market value of debt is determined by the rate of return demanded by the investors which in turn is determined by general interest rates. Once the debt has been issued the company has no control over the market value.
Dear Sir,
could u please further elaborate that How Market price of a Share of a company (or Market Cap in total) includes all of its Reserves too?
Thanks in advance.
The most obvious reason for a company’s shares being valued at more than their nominal value is because it has been making profits.
A full discussion as to what determines the market value of shares is covered in the chapters and lectures on the valuation of securities.
Hi Sir, isn’t it the fact that higher debt increases risk of default hence why it increases risk for shareholders?
At very high levels of debt then it does increase the risk (although debt lenders themselves will usually not lend at very high levels of gearing).
The main risk is due to the fixed interest as I explain the lectures, and this occurs at all levels of debt borrowing (albeit more debt means more risk because of more fixed interest).
sir it says p.c in the notes so shouln’t it be multiplied by 0.95 in dollar terms?
The book value (nominal value) is $100,000 from the SOFP.
The market value is $95 per $100 nominal and is therefore $95,000.
Sir why is market value more relaible measure?
Because values in the SOFP never represent the true value of a business.
Thank you very much Mr. Moffat for making the lecture notes and videos COMPLETELY free and available, you saved me a fortune in ACCA online tutorials, may God continue to bless you and your family in Jesus name, I am truly grateful…….
I just discovered your website recently, I am going to use them and recommend them to my friends for my ACCA and CIMA exams…..
Thank you for your comments 🙂
Its obviously a silly question, but just to confirm it and be calm for sure, haha. By “reserves” as this, we mean the retained earnings, right? It is not the share premium reserve, that you might get from a right’s issue, let’s say. Both the share premium and RE are actually included together with the share capital as part of the total equity, right?
Reserves are all amounts owed to shareholders in addition to the share capital, so they include both retained earnings and the share premium account. If we are using book values then the total equity is the share capital plus all reserves.
why dont we include reserves in equity while using market values
Because the most obvious reason that the market value is higher than the nominal value is because the company has made profits. Effectively the market value includes the retained earnings (and I do say this in my lectures).
I have the same question. Even though I watched your lecture and read your comment here, I still don’t understand why we don’t recalculate the Reserves with effect of market value. I don’t understand why market value includes the reserves. The reserves on Financial Position St is $130,000 meanwhile the Share Capital (10c per share) has nominal value of $10,000. (the reserves value > share capital value, does it mean the reserves is the money saved from many years?). Could you please explain in detail with numbers or in another way easier to help me understand why the Equity included reserves already? I guess because I don’t know the basics and don’t understand the financial positions thoroughly. Please help me!!!
You will know from Paper FA (was F3) that the SOFP does not show the true value of a business – the non-current assets are shown at cost less depreciation which is not the same as the true value, and internally generated goodwill does not appear on the SOFP.
The true value of the equity is what investors are willing to pay for the shares in the business i.e. the market value of the shares.
Thank you so much John!!!! I’ll watch FA videos too. For this specific example though, the market value is what investors are willing to pay for the shares. Here the number of shares is 100,000 shares and market value is $2.2 per share. So it means this $220,000 equity will partly used for paying dividends and the remaining is retained as Reserves. (Am I correct? is this what you mean from market value includes REs?) So on the SOFP, the Reserves is $130,000 is this accumulated REs or Opening REs…..? what is the role of this number, so we just ignore it?
No. You should remember from Paper FA (was Paper F3) or whatever exempted you from it, that the reserves are simply the total profits that have been retained in the company (i.e. not paid out as dividend). However the figures that appear in the SOFP (and in the SOPL when calculating the profit) do not represent the real position of the business.
Let me give you just one example. Suppose the business bought a building 20 years ago for $10,000. It will have been depreciated and suppose that the net book value (which is what appears on the SOFP) is now only $4,000.
It could be that the building is actually worth now $100,000. However this higher value will not appear in the SOFP and this ‘profit’ will not appear in the reserves either. However, if you were buying shares in the company you would regard to the company as being worth more than the figures that appear in the SOFP.
This is only one tiny example. The main reason the market value of shares is what it is, is because it is based on the future dividends that shareholders expect to receive. If they think the company is going to pay higher dividends in the future then they will pay more for the shares. (This is all explained in the later lectures on the valuation of shares).
The main point here is that the figures on the SOFP are not showing the ‘true’ value of the business at all, and never do.
Why do we take 100000 debentures when calculating the gearing? The second formula says ordinary share capital + reserves? Thnx 🙂
Debentures are long term debt borrowing, and both formulae for gearing include long-term debt. Gearing is a measure of the proportion of long-term debt!