Analysis Of Published Accounts: Gearing Ratio (Copy)

10.2 Business Accounts And Analysis

10.2.4 Gearing Ratio

The Meaning And Importance Of Gearing

• Definition of gearing
  • Gearing measures the proportion of a business’s capital that is financed by debt (borrowed funds) compared to equity (shareholders’ funds).
  • It shows the degree to which a business is dependent on external borrowing versus owners’ investment.
• High gearing
  • A business is said to be highly geared if a large proportion of its capital comes from debt (loans, debentures).
  • This means higher financial risk because interest and loan repayments must be made regardless of profits.
• Low gearing
  • A business is low geared if it relies more on equity than debt.
  • Safer in times of uncertainty, but may mean slower growth because equity is usually more expensive than debt (dividends expected, but less risk for lenders).
• Importance of gearing
  • Risk assessment: Investors and banks use gearing to assess financial stability.
  • Impact on profits: High interest payments reduce profit available for dividends.
  • Control: Highly geared firms are more dependent on lenders, reducing independence.
  • Growth potential: Debt can finance expansion without diluting ownership, but too much may lead to insolvency.
  • Decision-making: Managers must decide optimal debt–equity mix to balance growth and risk.
• Real-world example
  • Utility companies (e.g., National Grid) often operate with high gearing because they have predictable, stable cash flows.
  • Tech start-ups often have low gearing but high equity financing because lenders see them as too risky.

Gearing Ratio: Calculation And Interpretation

• Formula

  Gearing Ratio=Non-current LiabilitiesCapital Employed×100text{Gearing Ratio} = frac{text{Non-current Liabilities}}{text{Capital Employed}} times 100

• Where:
  • Non-current liabilities = long-term borrowings (bank loans, debentures, mortgages).
  • Capital employed = Non-current liabilities + Shareholders’ equity.
• Interpretation
  • Expressed as a percentage.
  • Low gearing (<50%): Most capital comes from equity, less financial risk, but may suggest under-utilisation of cheap debt finance.
  • High gearing (>50%): More capital comes from debt, which increases risk due to fixed interest payments. Suitable only if the business has steady cash inflows.
  • Moderate gearing (25%–50%): Generally considered a healthy balance.
• Example Calculation
  • Non-current liabilities = $600,000
  • Shareholders’ equity = $900,000
  • Capital employed = 600,000 + 900,000 = $1,500,000
  • Gearing Ratio = (600,000 ÷ 1,500,000) × 100 = 40%
  • Interpretation: Low gearing. Business relies more on equity, less risky, but may not be taking advantage of potential debt benefits.

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

Methods Of Improving Gearing

• Reducing reliance on debt
  • Repay long-term loans early to reduce gearing.
  • Use retained profits for expansion instead of borrowing.
• Increasing equity finance
  • Issue new shares to raise funds.
  • Example: Tesla raised billions through share issues rather than relying solely on debt.
  • Attract new investors to increase total equity.
• Improving profitability
  • Higher retained profits increase equity, reducing the gearing ratio.
  • Strategies include cost reduction, product differentiation, and efficiency improvements.
• Convert debt to equity
  • Negotiate with lenders to convert debt into shares.
  • Reduces liabilities, but existing owners may lose some control.
• Lease assets instead of buying
  • Leasing reduces the need for large loans to purchase equipment.
  • This limits long-term liabilities and helps maintain lower gearing.
• Retain earnings rather than paying dividends
  • Businesses may reduce dividend payouts to shareholders to build up equity reserves.
  • Example: During the 2008 financial crisis, many banks reduced or suspended dividends to strengthen their capital base.
• Seek government support or subsidies
  • In industries such as renewable energy, government grants can reduce the need for borrowing.

Strategic Considerations

• Impact of high gearing
  • Risk of financial distress during downturns.
  • Shareholders may expect higher returns due to risk.
  • Lenders may demand higher interest or security.
• When high gearing is acceptable
  • Stable industries (utilities, railways, telecom).
  • When interest rates are low, making debt cheaper than equity.
  • When growth opportunities require large investments.
• When low gearing is preferable
  • Start-ups with uncertain cash flow.
  • Businesses in cyclical industries (tourism, construction).
  • Firms aiming to maintain independence from banks.
• Link to investment appraisal
  • Gearing affects cost of capital (WACC).
  • High gearing increases financial risk, which may discourage long-term investment.
• Investor perspective
  • Conservative investors prefer low gearing.
  • Risk-seeking investors may accept higher gearing for higher returns.

Links Between Gearing And Other Business Functions

• Finance
  • High gearing increases interest payments → reduces net profit.
  • Affects dividend policy and shareholder satisfaction.
  • Influences cost of capital and investment decisions.
• Liquidity
  • High gearing → higher interest and repayments → strain on cash flow.
  • May lead to liquidity problems if cash inflows are irregular.
• Operations
  • High gearing firms may face pressure to cut costs, affecting quality.
  • Limits flexibility in production changes due to debt commitments.
• Human resources
  • High gearing may cause job insecurity, affecting morale and motivation.
  • Low morale can reduce productivity and increase staff turnover.
• Strategic growth
  • Gearing allows firms to expand rapidly without issuing shares.
  • But overreliance on debt can threaten long-term survival.

Diagram – Gearing Ratio

          Gearing Ratio Formula

          Non-current Liabilities
Gearing = ----------------------  × 100
           Capital Employed

Where:
Capital Employed = Non-current Liabilities + Shareholders’ Equity

Example:
Non-current Liabilities = $600,000
Shareholders’ Equity = $900,000
Capital Employed = $1,500,000

Gearing Ratio = (600,000 ÷ 1,500,000) × 100 = 40%

• Illustrates how a higher proportion of debt increases the gearing ratio.

Key Insights

• Gearing measures the reliance on debt compared to equity.
• High gearing = higher risk but potential for faster growth.
• Low gearing = safer finances but may limit expansion.
• Businesses can improve gearing by repaying debt, raising equity, retaining profits, or leasing assets.
• Gearing links closely with liquidity, profitability, operations, and HR strategy.
• Finding the right balance in gearing is crucial for long-term financial stability.

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