1. Ratio Analysis - Gearing
3.5 Assessing competitiveness

2. What you need to know
Gearing ratio

3. Concept links Gearing Business failure Equity & debt Interest rates
Sources of finance
Equity & debt
Business failure
Interest rates
Liquidity

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

5. Why is the Gearing Ratio Useful?
Measure of the financial health of a business
Focuses on the level of debt in the financial structure of a business
High gearing can mean high business risk (but not always)

6. Two Ways of Measuring Gearing
Debt / Equity
Ratio
Gearing
Ratio

7. 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 PARTS 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

8. Examples of Two Different Capital Structures
Extract from the Balance Sheet on 31/12/XX
BUSINESS A
£’000
BUSINESS B
Share capital [A]
500
300
Retained profits [B]
100
Bank loan [C]
200
Other loan capital [D]
Total Capital
1,000
Made up of…
Total Equity [A + B]
800
400
Total Debt [C + D]
600

9. Capital Structure Objective: The Debt / Equity Ratio
This the proportion (percentage) of a business’ capital made up from
EQUITY and DEBT
BUSINESS A
£’000
BUSINESS B
Debt
200
Debt
600
Equity
800
Equity
400
= 25%
= 150%

10. Capital Structure Objectives
Reasons for higher equity in the capital structure
Where there is greater business risk (e.g. a startup)
Where more flexibility 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

11. Non-current liabilities Total equity + non-current liabilities
The Gearing Ratio (%)
Gearing % =
Non-current liabilities
X 100
Total equity + non-current liabilities

12. Simple Example of Gearing %
£million
Business C
Business D
Non-Current Liabilities (A)
200
500
Total Equity (B)
600
300
Equity + Non-Current Liabilities (A + B)
800
Gearing (A) / (A + B)
200 / 800
500 / 800
Gearing %
25%
62.5%

13. Evaluating the Gearing %
Gearing ratio of 50% + normally said to be high
Gearing of less than 20% normally said to be low
But level of acceptable gearing depends on business & industry

14. Benefits of High Gearing
Less capital required to be invested by the shareholders
Debt can be a relatively cheap source of finance compared with dividends
Easy to pay interest if profits and cash flows are strong

15. Benefits of Low Gearing
Less risk of defaulting on debts
Shareholders rather than debt providers “call the shots”
Business has the capacity to add debt if required