Accounting for Managers: Interpreting accounting information for decision-making

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86 ACCOUNTING FOR MANAGERS


Table 7.1 Risk and return – effect of different debt/equity mix


100% equity 50% equity
50% debt

10% equity
90% debt

Capital employed 100,000 100,000 100,000


Equity 100,000 50,000 10,000
Debt 0 50,000 90,000


Operating profit before interest and tax 20,000 20,000 20,000
Interest at 10% on debt 0 5,000 9,000


Profit after interest 20,000 15,000 11,000
Tax at 30% 6,000 4,500 3,300


Profit after tax 14,000 10,500 7,700


Return on investment 14% 21% 77%


Interest cover


profit before interest and tax
interest payable

100


16


= 6 .25 times

The higher the gearing, the higher the risk of repaying debt and interest. The lower
the interest cover, the more pressure there ison profits to fund interest charges.
However, because external funds are being used, therate of profitearned by
shareholders is higher where external funds are used. The relationship between
risk and return is an important feature of interpreting business performance.
Consider the example in Table 7.1 of risk and return for a business whose capital
employed is derived from different mixes of debt and equity.
While in the above example the return on capital employed is a constant 20%
(an operating profit of £20,000 on capital employed of £100,000), the return on
shareholders’ funds increases as debt replaces equity. This improvement to the
return to shareholders carries a risk, which increases as the proportion of profits
taken by the interest charge increases (and is reflected in the interest cover ratio).
If profits turn down, there are substantially more risks carried by the highly
geared business.


Activity/efficiency......................................


Asset turnover


sales
total assets

2 , 000


1 , 150 + 500


=121%

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