86 ACCOUNTING FOR MANAGERS
Table 7.1 Risk and return – effect of different debt/equity mix
100% equity 50% equity
50% debt10% equity
90% debtCapital 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 payable100
16
= 6 .25 timesThe 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