Analysis Of Published Accounts: Gearing Ratio (Copy)

10.2 Accounting Ratios

10.2.4 Gearing Ratio

1. Meaning and Importance of Gearing

• Gearing: Measures the proportion of a business’s capital financed by long-term debt compared to equity.
• Importance:
  • Indicates financial risk: high gearing → high debt → higher interest obligations → higher risk.
  • Helps investors and lenders assess financial stability.
  • Guides decisions on capital structure and funding.

2. Gearing Ratio

• Formula:
  Gearing Ratio (%) = (Long-Term Liabilities ÷ (Shareholders’ Equity + Long-Term Liabilities)) × 100
• Interpretation:
  • Low gearing (<50%): less risky, majority financed by equity.
  • High gearing (>50%): riskier, majority financed by debt, higher interest burden.
  • Moderate gearing can increase return on equity if business generates higher returns than interest on debt.
• Example:
  • Long-Term Liabilities = $200,000
  • Shareholders’ Equity = $300,000
  • Gearing Ratio = (200,000 ÷ (300,000 + 200,000)) × 100 = 40% ✅
  • Interpretation: low gearing, low financial risk.

3. Methods of Improving Gearing

• Reduce debt:
  • Pay off long-term loans using retained profits or equity.
• Increase equity:
  • Issue new shares to raise capital.
• Restructure debt:
  • Replace high-interest loans with lower-interest options.
• Profit retention:
  • Retain profits rather than distribute as dividends to increase equity.

Written and Compiled By Sir Hunain Zia, World Record Holder With 154 Total A Grades, 7 Distinctions and 11 World Records For Educate A Change A2 Level Business Full Scale Course