Activity 6: Calculating gearing
Calculate a gearing ratio to assess the financial risk of Lonmin plc. What does the ratio tell you?
Go to the balance sheet on p. 93 of the annual report and accounts to find the figures for ‘Total equity’, and ‘Interest bearing loans and borrowings’ (short and long-term) for the financial year 2009.
Note: a gearing ratio is calculated as Debt (short- and long-term)/(Debt (short- and long-term) + Equity).
Debt (short- and long-term)/(Debt (short- and long-term) + Equity) = ($58m + $349m)/($58m + $349m + $2,802m) = 12.68%.
Note that the denominator is $3,209m.
Lonmin plc’s senior managers have made a strategic decision to fund their business primarily with equity. It may be preferable for Lonmin plc to use equity if the appetite of shareholders (investors) for Lonmin is high.
The size of the retained earnings (previous profits) shows that Lonmin has been able to generate profits in the past and that these retained earnings are available for dividend payments (something shareholders like!).
Also, it may be that debt finance (bank lending) is not available, or attractive enough to Lonmin plc at a price (interest rate) they are prepared to pay. It is worth taking a look at Lonmin plc’s income statement. The loss in 2009 and the uncertain outlook for 2010 may be a good reason for not increasing debt on the balance sheet.
Go to p. 126 to see details of the rights issue made by Lonmin plc in 2009 (note 29).
Raising the $458m (see note 29) in debt rather than equity would result in a debt/debt + equity ratio of 26.96%. Lonmin plc would then look riskier to equity investors.
Debt (short- and long-term)/(Debt (short- and long-term) + Equity) = ($58m + $349m + $458m/($3,209m) = 26.96%.
The denominator in the gearing ratio remains the same. However, the numerator shows the additional amount of debt has increased.
Activity 7: Lonmin’s external financing
What do you think Lonmin plc uses its external financing for? Look at the balance sheet (p. 93) and find the ‘big figures’.
Lonmin plc has $2,036m invested in property, plant and equipment and $964m in intangible assets. Go to the relevant notes to see more details. Lonmin plc has decided to fund its investment in mining equipment with equity.
The take-up of the rights issue indicates that shareholders and investors are happy with this approach – they see this asset investment combined with Lonmin plc’s strategic ability to use the assets to generate profits as a strategy that will create future value for shareholders, both on the balance sheet (as retained earnings increase) and in the share price as well. See Lonmin’s comments on this on p. 76 of the annual report (bearing in mind that companies usually stress the positives when commenting on their own performance!).
Note: the lack of suitable debt finance was one of the reasons for the prevalence of rights issues by all companies in 2009. Type ‘rights issues in 2009’ into any search engine to get a quick overview of why there were so many rights issues offered by companies in 2009.
Although we started this activity by looking at the liabilities on the balance sheet that are external sources of financing, we ended by reviewing other areas of the annual report and accounts (the income statement and notes). We could also have looked at the cash flow statement (p. 94 of the annual report and accounts).
These areas help us make sense of the ‘picture’ of Lonmin and show us that when we consider financing, we also need to consider how the financing will be used.
A key question is whether these strategic financing choices will create wealth for businesses and the shareholders. This needs to be kept in mind.