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Gearing Ratio

Author: Jim Riley  Last updated: Sunday 23 September, 2012

Introduction to accounting

Gearing ratio

Gearing focuses on the capital structure of the business – that means the proportion of finance that is provided by debt relative to the finance provided by equity (or shareholders).

The gearing ratio is also concerned with liquidity.  However, it focuses on the long-term financial stability of a business.
Gearing (otherwise known as "leverage") measures the proportion of assets invested in a business that are financed by long-term borrowing.

In theory, the higher the level of borrowing (gearing) the higher are the risks to a business, since the payment of interest and repayment of debts are not "optional" in the same way as dividends. However, gearing can be a financially sound part of a business's capital structure particularly if the business has strong, predictable cash flows.

The formula for calculating gearing is:

Formula for calculating the gearing ratio

Long-term liabilities include loans due more than one year + preference shares + mortgages
Capital employed = Share capital + retained earnings + long-term liabilities


The gearing calculation can be calculated like this:

 

2012
£’000

2011
£’000

Long-term liabilities

1,200

1,450

Capital employed

5,655

4,675

Gearing ratio

21.2%

31.0%

According to the data the gearing ratio at 31 December 2012 was 21.2%, a reduction from 31.0% a year earlier.  This was largely because the business reduced long-term borrowings by £200,000 and added over £1million to retained earnings.

How can the gearing ratio be evaluated?

  • A business with a gearing ratio of more than 50% is traditionally said to be “highly geared”.
  • A business with gearing of less than 25% is traditionally described as having “low gearing”
  • Something between 25% - 50% would be considered normal for a well-established business which is happy to finance its activities using debt.

For the above business, that would suggest that the business is relatively lowly-geared and that the capital structure of the business is pretty safe and cautious.

It is important to remember that financing a business through long-term debt is not necessarily a bad thing!  Long-term debt is normally cheap, and it reduces the amount that shareholders have to invest in the business.

What is a sensible level of gearing?  Much depends on the ability of the business to grow profits and generate positive cash flow to service the debt.  A mature business which produces strong and reliable cash flows can handle a much higher level of gearing than a business where the cash flows are unpredictable and uncertain.

Another important point to remember is that the long-term capital structure of the business is very much in the control of the shareholders and management.  Steps can be taken to change or manage the level of gearing – for example:

Reduce Gearing

Increase Gearing

Focus on profit improvement (e.g. cost minimisation

Focus on growth – invest in revenue growth rather than profit

Repay long-term loans

Convert short-term debt into long-term loans

Retain profits rather than pay dividends

Buy-back ordinary shares

Issue more shares

Pay increased dividends out of retained earnings

Convert loans into equity

Issue preference shares or debentures



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Starting a Business

Sources of Finance for a Startup
Franchising
Cash Flow Forecasting for a Startup
Creating & Protecting Business Ideas
Startups and Understanding the Market
Market Research for a Startup
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Generating and Protecting a Business Idea
Using Breakeven in Decision-Making

Finance

Revenues
Breakeven Basics
Costs, Revenues and Profits
Business Costs
Using Budgets
Using Breakeven in Decision-Making
Investment Appraisal Basics
Financial Strategies
Measuring and Improving Profit
Improving Cash Flow
Working Capital
Balance Sheet
Income Statement
Financial Efficiency Ratios
Profitability Ratios and ROCE
Liquidity Ratios
Gearing

Marketing

Competition
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Place (Distribution)
Promotion
Pricing
Price Elasticity of Demand

Business Organisation

Basics of Business Growth
Business Activities
Legal Structure Basics
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Business Strategy

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Related study notes

INTRODUCTION TO ACCOUNTS
Introduction to Accounting
Users of Accounts
Accounting Concepts and Conventions
Stakeholder Theory
Characteristics of Accounting Information
Alternatives to Profit Maximisation
Maximising the Value of a Business
Non-financial Objectives of a Business
Comparison of Financial and Management Accounting

BUDGETING
Financial objectives - intro
Financial objectives - key measures
Introduction to Business Planning
Introduction to Budgets
Purpose and Role of Budgets
Incremental Budgeting
Zero-based Budgeting
Variance analysis
Budgeting limitations

COMPANY FORMATION
Introduction to Business Organisation
Forming a Company
Advantages of Incorporation

FINANCIAL MANAGEMENT
Introduction to Financial Management
Introduction to Working Capital
Working Capital Needs of Different Businesses
Working Capital Cycle

SOURCES OF FINANCE
Managing Business Cash Flows - An Introduction
Introduction to Raising Business Finance
Sources of Finance for SMEs
Overdraft Financing
Business Angels
Introduction to Venture Capital
Sources of Equity Finance
Rights Issues
New Share Issues & Flotations
Intoduction to Leasing
Leasing - Advantages & Disadvantages

FINANCIAL STATEMENTS
Introduction to Financial Accounting
Income Statement
Profit quality
Balance Sheet
Current assets
Current liabilities

RATIO ANALYSIS
Introduction to Ratio Analysis
Interpreting Financial Information
Accounts & financial performance
ROCE
Asset turnover
Stock turnover
Debtor days
Creditor days
Liquidity ratios
Gearing ratio
Shareholder ratios
Limitations of ratios

ACCOUNTING ISSUES
Accounting for Fixed Assets - Introduction
Depreciation
Depreciation - Straightline Method
Depreciation - Reducing Balance Method

STAKEHOLDERS
Stakeholders - intro
Stakeholder power
Stakeholder conflicts

 


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