The gearing ratio

What is the gearing ratio?

The gearing ratio calculates the proportion (%) of capital employed that is financed by long-term liabilities.

How is gearing calculated?

Gearing= long term liabilities / capital employed x 100

Why is the gearing ratio important?

This ratio is important because it is an indicator of the financial risk associated with a business. If a company has too much debt, it can fall into financial trouble. In theory, the higher the level of borrowing (gearing), the higher the risks are 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.

There is nothing wrong with a business taking out loans in order to expand. This is often an excellent way to finance expansion, but there are dangers if a business tries to expand too fast and borrows too much or if there are economic issues. For example, many large businesses found themselves in serious trouble in 2008 when the economy went into recession and their expansion plans failed as consumers stopped buying their goods and services.

How do you evaluate the gearing ratio?

• 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.

Is a highly geared business a sign of poor financial performance?

No.

Financing a business through long-term debt is normally cheap, and it reduces the amount that shareholders have to invest in the business.

The appropriate level of gearing depends on the ability of the business to grow profits and generate positive cash flow to pay for the debt. A strong business which produces good and reliable cash flows can handle a much higher level of gearing than a business where the cash flows are unpredictable and uncertain.

How can a business reduce its gearing?

• Focus on profit improvement (e.g. cost minimisation).

• Repay long term loans.

• Retain profits rather than pay dividends.

• Issue more shares.

• Convert loans to equity.

How can a business increase its gearing?

• Focus on growth- invest in revenue growth rather than profit.

• Convert short term debts into long term loans.

• Pay increased dividends out of retained earnings.