3.5.2 gearing

Define gearing

measures the proportion of a business capital(finance) provided by debt

What does gearing show

It shows the proportion of debt to equity and helps assess the financial risk of the business

What’s the formula for gearing

Gearing% = non current liabilities/total equity+non current liabilities x100

What are non current liabilities also known as

Total debt

What are the two measures of gearing

Debt/equity ratio

Gearing ratio

What’s the capital structure of a business

Represents the finance provided to it to enable it to operate over the long term

What’s equity

Amounts invested by the owners of the business eg share capital and retained profits

What’s debt

Finance provided to the business by external parties eg bank loans/ other long term debt

What’s the debt/ equity Ratio

Debt/ratio , it’s the percentage of a business capital(finance) made up from equity and debt

What are the reasons for higher equity in the capital structure

Where there is greater business risk eg startup

Where there’s more flexibility eg don’t have to pay dividends

What’s the reason for higher debt in a business

Where interest rates are very low as borrowing is cheaper so debt is easy to finance

Where profits and cash flow are strong so debt can be repaid easily

What does the gearing ratio have to be to evaluate wether it’s high or low

Gearing ratio of 50% or more is high

Gearing ratio of less then 20% is low

What does a high gearing ratio indicate for the business

Indicates a higher level of financial risk as the company relies more on debt for financing

What does a low gearing ratio suggest

Lower financial risk but may also mean few growth opportunities

What are the benefits of high gearing

Less need for shareholders to invest funds for the business

Debt can be a relatively cheap source of finance compared with dividends

Increased returns on equity and growth as a higher proportion of debt can amplify returns for shareholders when the business performs well through higher dividends

What are the disadvantages of high gearing

Financial risk - increased vulnerability to economic downturns or unexpected events

Higher interest payments as a company relies on debt impacting cash flow

Benefits of low gearing

Less risk of defaulting on debts so during economic downturns there will be lower financial distress

there’s more flexibility for changes in financial decisions as the business has the capacity to add debt if required

Disadvantages of low gearing

Reduced ROE, shareholders may see lower returns compared to a business with higher gearing

More reliance on shareholders investments which can slow down growth

What are the key factors affecting gearing

Industry norms- gearing ratios can vary across industries eg automotive manufacturing and airline business have high gearing as they rely on purchasing heavy machinery eg plants, parts exc

Interest rates- higher I/r may increase the cost of debt

Business life cycle- start ups may have high gearing to fund growth to start up whilst mature companies may prefer low gearing for stability

What is return on capital employed (ROCE)

A performance indicator that tells how well a company uses its capital invested to generate profits

What’s the formula for ROCE

ROCE= operating profits/ capital employed x100

ROCE= operating profits/ total equity+ non current liabilities x100

What is capital employed

Total money used in a business it’s equity plus debt

What does a higher ROCE suggest

A higher ROCE suggests a business is really good at turning its capital into profit. Indicates good profitability and using capital efficiently

What rate of ROCE do investors prefer

Stable and rising ROCE of as least 20% as its lower risk growth

Can both net profit and operating profit be used in calculation ROCE

Yes, the key difference is interest and tax is in net profit and operating profit doesn’t take them into account this can create a more accurate ROCE

Why is EBT operating profit better use than net profit

EBT operating profit excludes interest and tax, making it a fair comparison it’s more accurate of a business financial health

Net profit includes interest and tax so companies with debt would appear less efficient even if their operations are great

Advantages of a high ROCE

Efficient capital use- signifies the effective use of capital to generate profits

Better for investors- companies with higher gearing roce are often more attractive to investors as they demonstrate strong profitability

Disadvantages for high RoCE

Risk of to much debt used is roce is used through debt eg bank loans

Difficult to maintain as it can change based on economic and external factors eg during economic downturn roce can decrease sign

Key things to consider for ROCE

Compare ROCE overtime and against industry averages for a more meaningful insight

Consider the risk return trade off as extremely high ROCE may involve higher risks

Advantages of low ROCE

A more conservative approach can avoid excess debt and achieve financial stability

Capital preservation a business can save capital for emergency situations eg economic downturns

Disadvantages of low ROCE

Limited profitability not efficiently utilising its capital to maximise profits

Potentially miss out of profit max investments may reduce shareholder dividends thus confidence