Gearing Ratio (Cambridge International A-Level Business)

The meaning and importance of gearing

• Gearing shows the balance between debt and equity finance in a business

  • High gearing means a business has a high level of borrowing in relation to equity capital

    • A business with high gearing is higher risk but could potentially generate higher returns

  • Low gearing means a business has a low level of borrowing in relation to equity capital

    • A business with low gearing is lower risk but fast growth may be limited as it has a more cautious approach to borrowing

Why is gearing important?

• Assesses financial risk

  • High gearing means higher risk, as the business must make regular loan repayments and pay interest, even if profits fall

• Useful for lenders and investors

  • Banks and investors use the gearing ratio to judge whether the business can afford to take on more debt or is too risky to support

• Helps in decision-making

  • Businesses with low gearing may choose to borrow more to expand, while highly geared firms may focus on reducing debt before growing

The gearing ratio

• The gearing ratio is calculated using the formula and is expressed as a percentage

$\mathrm{Gearing} \mathrm{ratio}=\frac{\mathrm{Non}-\mathrm{current} \mathrm{liabilities}}{\mathrm{Capital} \mathrm{employed}}x100$

• Capital employed is calculated using the formula

$\mathrm{Capital} \mathrm{employed}=\mathrm{Issued} \mathrm{shares}+\mathrm{Reserves}+\mathrm{Non}-\mathrm{current} \mathrm{liabilities}$

• The higher the gearing ratio, the more dependent a business is on long-term borrowing

Worked Example The table shows an extract from the company accounts of Walders Travel Ltd

	$
Current assets	6.2 million
Current liabilities	3.4 million
Non-current liabilities	9.6 million
Capital employed	43.3 million

**Calculate **Walders Travel Ltd's gearing ratio.

(2)

** Step 1: Identify data required to calculate the gearing ratio**

Non minus current space liabilities space equals space $9.6 space million Capital space employed space equals space$ 43.3 space million

Step 2: Divide non-current liabilities by capital employed

equals space $43.3 space million space divided by space$ 9.6 space million

equals space 0.22 (1)

Step 3: Multiple the outcome by 100 and express the result as a percentage

$= 0.22 \times 100$

equals space 22 percent sign (1)

• 22% of Walders Travel Ltd's capital structure is made up of long-term loans, showing it is a low-geared business

Risks of high gearing

• High or increasing gearing can be problematic for several reasons

Methods of improving gearing

• Improving the gearing ratio usually means lowering it to reduce risk

1. Reduce long-term borrowing

• Repay existing debt to lower financial risk
• Prioritise paying off high-interest debt to minimise interest costs over time
• Negotiate with creditors to restructure existing debt, such as extending repayment periods or lowering interest rates

1. Raise equity capital

• Raise share capital by issuing new shares to investors
• Consider a rights issue, offering existing shareholders the opportunity to buy additional shares
• Retain profits within the business instead of distributing them as dividends to shareholders, using them to fund growth or reduce reliance on borrowing

Situations where high gearing is less problematic

1. When interest rates are low and expected to remain low

• Interest rates in Europe have been historically low for more than a decade
• Many businesses have taken advantage of borrowing cheaply to fund investment

1. Large and profitable businesses are capable of meeting debt obligations

• Multinational car manufacturers such as Toyota and Volkswagen are highly geared
• High levels of borrowing have funded research into new generations of electric vehicles