Question

a) A company may choose to finance its activities mainly by equity capital, with low borrowings (low gearing) or by relying on high borrowings with relatively low equity capital (high gearing). Explain why a highly geared company is generally more risky from an investor’s point of view than a company with low gearing. (b) Ratio analysis in general can be useful in comparing the performance of two companies, but it has its limitations. State and briefly explain five of such limitations

Answer 1

a) Highly geared company means company with high debt in their balance sheet. As a result of this the company would be at greater financial risk , because during the times of low revenue and lower profits, the company needs to bear higher interest rates, the company would become more susceptible to bankruptcy which makes the investors to loose all their capital.

b) some of the limitations of ratio analysis are:

1) The firm can make some year end changes to their financial statements, to improve their ratios. Then the ratios end up being nothing but window dressing.

2) ratios ignore the price level changes due to inflation. Many ratios are calculated using historical costs, and they overlook the changes in price level between the periods. This does not reflect the correct financial statements.

3) Accounting ratios completely ignore the qualitative aspects of the firm. They only take into consideration of monetary aspects.

4) There are no standard definitions of the ratios. so firms may using different formulas for the ratios. One such is current ratios they ignore bank overdrafts in current liabilities.

5) Accounting ratios do not resolve any financial problems of the company. They are a means to end , not the actual solution.