ExpertMedium2 marksMultiple Choice
ACCA · Question 30 · Interpretation of Financial Statements
Section A
A company has a gearing ratio (Debt / (Debt + Equity)) of 40%. It decides to issue $2 million of new ordinary shares and uses the proceeds entirely to repay an existing long-term bank loan. What will be the effect on the gearing ratio?
Section A
A company has a gearing ratio (Debt / (Debt + Equity)) of 40%. It decides to issue $2 million of new ordinary shares and uses the proceeds entirely to repay an existing long-term bank loan. What will be the effect on the gearing ratio?
Answer options:
A.
It will increase.
B.
It will decrease.
C.
It will remain unchanged.
D.
It cannot be determined without knowing the total assets.
How to approach this question
Analyze the formula: Debt / (Debt + Equity). The transaction decreases Debt and increases Equity by the same amount. The denominator stays constant, but the numerator decreases. Thus, the ratio decreases.
Full Answer
B.It will decrease.✓ Correct
Gearing measures the proportion of a company's financing that comes from debt. By issuing shares (increasing equity) to pay off a loan (decreasing debt), the company is reducing its debt burden. Mathematically, the numerator (Debt) decreases while the denominator (Debt + Equity) remains constant, resulting in a lower gearing ratio.
Common mistakes
Assuming that because the total capital employed (Debt + Equity) doesn't change, the ratio doesn't change.
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