Gearing Ratio

• What is the gearing ratio?

  A capital structure ratio
• What does the gearing ratio measure?

  Capital structure within a business
• What are non-current liabilities?

  Long-term debts owed by a business
• What types of debts are considered non-current liabilities?

  Loans, mortgages, bonds, and debentures
• What is the formula for the gearing ratio?

  (Non-current liabilities / Capital employed) × 100
• Where can non-current liabilities be found?

  On the statement of financial position
• What is capital employed made up of?

  Total equity plus non-current liabilities
• What components make up total equity?

  Retained profits and share capital
• What does a higher gearing ratio indicate?

  More leverage and sensitivity to interest rates
• Why does a high gearing ratio increase sensitivity to interest rate increases?

  Higher costs due to increased borrowing costs
• What is considered a highly geared business?

  50% or higher gearing ratio
• What risks does a highly geared business face?

  Risk of liquidity issues with low profits
• What is considered a low gearing ratio?

  Less than 25% gearing ratio
• What is an acceptable gearing ratio range?

  Between 25% and 50%
• How have interest rates affected gearing ratios from 2009 to 2020?

  Interest rates were incredibly low during this period
• Why might a business want to lower its gearing ratio?

  To reduce risk in a rising interest rate environment
• When is a high gearing ratio more appropriate?

  When interest rates are low and profits are high
• When is a low gearing ratio more appropriate?

  In a high interest rate environment for security
• How can a business reduce its gearing ratio?

  By reducing non-current liabilities or increasing share capital
• What is a potential downside of reducing non-current liabilities?

  It may reduce cash levels and cause liquidity issues
• What is a potential downside of increasing share capital?

  It may lead to giving up control of the business
• What are the key considerations for a business regarding gearing ratios?

  • High gearing ratio:
  • Appropriate in low interest rates
  • Suitable with consistent high profits
  • Helps maintain control without issuing shares
  • Low gearing ratio:
  • Appropriate in high interest rates
  • Suitable with low or inconsistent profits
  • Allows expansion of shareholder base
• What factors influence a business's decision on its gearing ratio?

  • Current interest rates
  • Profit consistency and levels
  • Desire for control versus expansion
  • Liquidity concerns