Gearing

What is Gearing?

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

What are the different ways of measuring gearing?

• Debt/ Equity Ratio

• Gearing Ratio

What is the capital structure of a business?

• The capital of a business represents the finance provided to it to enable it to operate over the long-term. There are two part to the capital structure

• Equity:

  • Amounts invested by the owners of the business:

    • Share Capital

    • Retained Profits

• Debt:

  • Finance provided to the business by external parties:

    • Bank Loans

    • Other Long-Term Debt

What are capital structure objectives?

• Reasons for higher equity in the capital structure

  • Where there is greater business risk (e.g. a startup)

  • Where more flexibility is required (e.g. don’t have to pay dividends)

• Reasons why high levels of debt can be an objective

  • Where interest rates are very low debt is cheap to finance

  • Where profits and cash flows are strong; so debt can be repaid easily

What is the gearing ratio?

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

What are the evaluations of gearing?

• Gearing ratio of 50% + normally said to be high

• Gearing of less than 20% normally said to be low

• But levels of acceptable gearing depends on business and industry

What are benefits of high gearing ratios?

• Less capital required to be invested by shareholders

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

• Easy to pay interest if profits and cash flows are strong

What are benefits of low gearing ratios?

• Less risk of defaulting on debts

• Shareholders rather than debt providers ‘call the shots’

• Business has the capacity to add debt if required