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ACCA Strategic Professional · Strategic Business Leader · Financial analysis and decision-making techniques

Ardent Retail has gearing (debt/equity) of 150% and interest cover of 2.0 times. Its sector peers average gearing of 60% and interest cover of 7 times. Management proposes a large debt-funded store expansion. Which assessment is most appropriate?

Ardent already carries high financial risk, with gearing of 150% against a 60% peer average and interest cover of only 2.0 times against 7. Further debt-funded expansion could endanger solvency and breach covenants if profits decline, so the proposal needs careful scrutiny.

  1. AAdditional debt is attractive because debt is always cheaper than equity, so gearing should rise further
  2. BThe company already has high financial risk, so extra debt could threaten solvency and covenant compliance if profits fallCorrect
  3. CInterest cover of 2.0 times shows strong ability to service debt compared with peers
  4. DGearing is irrelevant because only liquidity ratios indicate financial risk

Explanation

Gearing well above peers and interest cover far below peers mean profits can fall only modestly before interest is not covered. More debt raises financial risk and the chance of covenant breach. Option A ignores rising cost of capital and risk.

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