Chapter 20

2.The draft statement of financial position of D Co at 31 March 20X3 shows the following Non-current assets450 Current assets Inventory65 Receivables110 Prepayments 30 Total assets655 Capital and reserves Issued capital400 Retained earnings100 Total equity  500 Non-current liabilities   Loan75 Current liabilities Payables30 Short-term borrowings (note 1)50 Total liabilities 155 Note 1: The short-term borrowings were raised on 30 September 20X2. What is the gearing ratio of D Co? A13 per cent B16 per cent C20 per cent D24 per cent (In this qn, please explain me how the answer is C?. The workings show that we take the the short term borrowings (6/12×50) plus non current liabilities divided by equity. Why do we include short-term debt??)

First question: The treatment in the SOPL has nothing to do with it. For the receivables period we need to take the average amount owing by customers (which will include sales tax) and the total amount invoiced to customers (which will also have included sales tax). Second question: Where did you find this question? We do not include short-term borrowings in calculating the gearing ratio. In addition there would be no logic whatsoever taking 6/12 of any borrowing even if it had been long-term borrowing.

Thank you for your explanation. I found both questions from the Kaplan lecturer resource pack. I also did not understand why they took short term borrowings and then time apportioned it. So, does it mean that option C for the second qn is not the correct answer?

I do not have the Kaplan books (only the BPP Revision Kit). However based on the question as you have typed it, the answer is certainly not 20%. It is 75/500 = 15%. (Given that you have the lecturers resource pack, you presumably have access to a lecturer - it would be interesting to see what explanation he or she attempts to give :-) )

Yes, I agree with you. We normally use only long term debt and equity. It is not possible for me to communicate with my lecturer sooner but I could post the explanation given within the resource pack...

"When you are asked to calculate a gearing ratio, you ought to be given information about the basis on which the ratio is calculated, because there are different ways of measuring gearing. In particular, gearing might be measured as the percentage ratio of long-term debt to total share capital and reserves. Alternatively, gearing could be measured as the percentage ratio of (long-term debt plus some short-term loans) to share capital and reserves. In this question, the problem is deciding what to do about the short-term borrowings of $50,000, which the enterprise has apparently had the benefit of for only the second half of the year. (1) If gearing is measured as long-term debt to share capital and reserves, the ratio would be (75/500) × 100% = 15%. This is not an option in the question. (2) If gearing is measured as (long-term debt plus short-term borrowings) to share capital and reserves, the ratio would be ((75 + 50)/500) × 100% = 25%. This is not an option in the question. (3) It might be assumed that since the short-term borrowings have only been in place for one half of the year, just one half of it ($25,000) should be included in debt, together with the long-term debt of $75,000. This would give a gearing percentage of ((75 + (1/2 × 50))/500) × 100% = 20%. This is an option in the question. Although it is possibly not the best way of measuring gearing, it is the most plausible of the four available answers." (This is what was explained, although don't you think it is not usual for such a method to be used?)

It is not usual at all and is wrong. We only include long-term debt (there is an argument for including a bank overdraft but only if it is made clear that it is intended to remain for the long-term - but that does not apply to this question). There is no logic whatsoever for taking 50% of the debt, even if it had been long-term debt.

Yes, I agree. Therfore, the correct formula is supposed to be long term debt/equity times 100? And sometimes, we could use capital employed if the qn tells us to put it as a denominator, right?

That is correct.

Ok, thank you.

You are welcome :-)