Gearing

• What is gearing?

  Gearing measures the proportion of a business' capital provided by debt
• What are the two parts of capital structure?

  Debt and equity
• What are the two parts of equity?

  Share capital and retained profits
• What is capital structure?

  Capital structure refers to the way a company finances its operations through a mix of debt and equity over the long term
• How do you calculate gearing?

  (Non-current liabilities)/(Capital employed) x 100
• What percentage is considered to be a high gearing ratio?

  50% +
• What percentage is considered to be a low gearing ratio?

  Less than 20%
• When would a higher gearing be appropriate?

  • Low interest rates
  • High profits - Able to pay debts more easily
  • Wants to keep control so avoids share capital
• When would a lower gearing ratio be appropriate?

  • High interest rates
  • Low or inconsistent profits
  • Happy to expand shareholders and lose control
• What is the problem with trying to reduce your non-current liabilities to reduce your gearing ratio?

  Cash and current assets are being spent on non-current liabilities which can damage cash flow and produce liquidity issues
• What other ratio might a business have to look at when seeing if they can decrease their non-current liabilities to reduce their gearing ratio and why?

  Current ratio because the business needs to know if they have enough current assets to spend on non-current liabilities and not run into liquidity problems
• What type of industry would usually have a high gearing ratio?

  Capital intensive industries
• What are ways of reducing the gearing ratio?

  • Decrease non-current liabilities
  • Focus on profit improvement (e.g. cost minimisation)
  • Retain profits rather than pay dividends
  • Increase share capital
• What are ways of increasing the gearing ratio?

  • Pay increased dividends out of retained profits - shareholders become happy
  • Issue less shares
  • Focus on growth - invest in revenue growth rather than profit
• What are the benefits of a high gearing ratio

  • Higher returns for shareholders if the company is able to generate strong profits
  • Easy to pay interest if profits and cash flow is strong
  • Quicker decision making because of less amount of shareholders
• What are the benefits of a low gearing ratio?

  • Shareholders can make the decisions rather than debt influencing the decisions
  • Business has the capacity to add debt if required
  • Less financial risk than a high gearing ratio