Gearing

• what is capital employed?

  money invested into the business to buy assets which are used to generate profit. it includes all the long term finance of the business
• capital employed equation?

  non-current liabilities + total equity
• what are non-current liabilities?

  refers to the long term loans of a business
• what is total equity?

  share capital + retained profits
• what is gearing ratio?

  measures the proportion of a businesses long term finance that is funded by long term loans
• what is the equation for gearing?

  non-current liabilities/capital employed x100
• with the gearing ratio firms can make sure they can:

  • take out additional loans
  • repay the borrowed amount
  • meet interest payments on loans
• advantages of high level of gearing? (over 50%)

  • manageable if there is a strong predictable cash flow
  • more feasible if the business has strong profitability and high levels of assets
  • helps a business take advantage of growth opportunities
  • raising finance without selling additional shares avoids dilution
• disadvantages of high level of gearing? (over 50%)

  • vulnerable to an interest rate rise
  • cash flow could change and the business may not be able to pay back loans
• advantages of low level of gearing? (<25%)

  • less risky
  • less affected by interest rate rise
  • provides scope to take out additional loans to fund new strategies
• disadvantages of low level of gearing? (<25%)

  • limits the businesses growth
  • may indicate a risk averse approach from management
• drawbacks of ratio analysis?

  • need to be compared over long term
  • only useful as the financial documents they are used on
  • comparison to competitors is needed
  • qualitative factors are ignored
  • external economic factors arent reflected in statements
  • reasons behind ratios must be explored