Gearing

What is “Gearing”?

“Gearing” measures the proportion of a business’ capital (finance) provided by debt.

What is the Capital Structure of a Business?

It represents the finance provided to enable the business to operate over the long-term, split into equity and debt.

What is Equity Finance?

Amounts invested by the owners of the business, e.g., share capital and retained profits.

What is Debt Finance?

Finance provided by external parties, e.g., bank loans and other long-term loans.

What factors influence the mix of equity and debt in a financial structure?

Business risk and flexibility (favoring equity); low interest rates and strong cash flows (favoring debt).

What are reasons for higher equity in a business?

Greater business risk (e.g., startup), more flexibility (no dividend payments).

What are reasons for higher debt in a business?

Low interest rates make debt cheap to finance; strong profits and cash flows make debt repayment easy.

What is the gearing ratio?

The proportion of a business’ finance that is debt, measured as Gearing % = (Non-current liabilities ÷ (Total equity + Non-current liabilities)) × 100.

Calculate the gearing ratio for Business A with Non-current liabilities = 200, Total equity = 600.

Gearing % = 200 ÷ (600 + 200) × 100 = 25%

Calculate the gearing ratio for Business B with Non-current liabilities = 500, Total equity = 300.

Gearing % = 500 ÷ (300 + 500) × 100 = 62.5%

What does a high gearing ratio (over 50%) indicate?

A higher risk of business failure but potentially cheaper finance than equity.

What does a low gearing ratio (below 20%) indicate?

Lower risk but possibly higher capital costs and less ability to leverage debt benefits.

What are benefits of high gearing?

Less capital needed from shareholders; debt can be cheaper than equity; easier to repay if profits/cash flows are strong.

What are benefits of low gearing?

Less risk of defaulting on debt; shareholders have more control; business can add debt if required.

Define 'Gearing'.

The proportion of a business’ capital structure that is in the form of debt.

Define 'Equity'.

The proportion and amount of capital provided by shareholders or left as retained profits.