Gearing

• What is gearing?

  measures the proportion of a business’s capital provided by debt
• capital structure


  represents the finance provided to it to enable it to operate over the long-term - 2 types : equity and debt
• equity finance

  amounts invested by the owners of the business , e.g. share capital
• debt finance


  finance provided to the business by external parties, e.g. bank loans
• reasons for higher equity

  where there is greater business risk - a start up

  where more flexibility is required - don’t have to pay dividends
• reasons for higher debt

  where interest rates are very low = debt is cheap to finance

  where profits and cash flows are strong so debt can be repaid easily
• benefits of calculating gearing

  -useful measure of the financial health of a business

  -focuses on the level of debt in the financial structure

  -higher gearing ratio can mean higher risk of business failure
• gearing formula


  (non current liabilities / total equity + n-c liabilities) x100
• benefits of high gearing

  -less capital required to be invested by the shareholders

  -debt can be a relatively cheap source of finance compared w dividends

  -easy to pay interest is profits and cash flow are strong
• benefits of low gearing

  -less risk of defaulting on debts

  -shareholders rather the debt providers make decisions

  -business has the capacity to add debt if required