The meaning and calculation of gearing

Gearing measures the proportion of a business's capital that comes from long-term debt compared to equity. It provides insight into the sources of finance.

Gearing indicates a business's vulnerability to interest rate changes, as higher borrowing increases exposure to rising rates. Businesses with strong profitability and valuable assets can often secure more loans, using those assets as security.

Formula for gearing

$\text{Gearing (\%)}=\frac{\text{non-current liabilities}}{\text{total equity}+\text{non-current liabilities}}\times 100$

Where:

• Non-current liabilities = Long-term debts, such as bank loans (£)
• Total equity = Share capital plus reserves (£)

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Worked example - Calculating gearing

A business has non-current liabilities of £200,000 and total equity of £300,000. Calculate the gearing percentage.

Step 1: Identify the values

• Non-current liabilities = £200,000
• Total equity = £300,000

Step 2: Apply the gearing formula

$\text{Gearing (\%)}=\frac{\pounds \mathrm{200,000}}{\pounds \mathrm{300,000}+\pounds \mathrm{200,000}}\times 100=40\%$

Levels of gearing

Gearing levels categorise businesses based on their reliance on long-term debt. Higher gearing often means more interest payments, which can reduce profits available for dividends.

Categories of gearing levels

• Above 50% (high-geared) - More than half of capital comes from long-term debt, indicating significant borrowing.
• 25% to 50% (standard gearing) - A moderate portion of finance is from long-term debt.
• Below 25% (low-geared) - Less than a quarter of capital is from long-term debt, showing reliance on equity.

Characteristics of low-geared and high-geared businesses

Businesses with different gearing levels exhibit distinct traits in their financing strategies and resilience.

Features of low-geared businesses

• Most long-term funds come from shareholders rather than borrowing.
• Indicates a cautious approach to risk.
• Better able to handle profit declines, as they can adjust dividends flexibly unlike fixed loan repayments.

Features of high-geared businesses

• Most long-term funds come from borrowing.
• Suggests a willingness to take risks.
• Must continue loan repayments regardless of profit fluctuations, risking loss of secured assets if payments fail.
• May use high gearing to fund expansion while keeping ownership control.

Rewards and risks of high gearing for businesses and investors

High gearing can offer opportunities for growth but introduces significant vulnerabilities. It affects both the business's operations and investor returns, particularly during economic changes.

Rewards for businesses

• Provides extra capital for expansion, investment in technology, and gaining competitive edges, especially in low-interest environments.
• Beneficial during business growth phases, allowing rapid scaling.

Risks for businesses

• May lead to inability to meet repayments if profits fall.
• Increases vulnerability to interest rate rises, raising borrowing costs.

Rewards for investors

• Lenders receive interest payments.
• Shareholders may get dividends and benefit from share price rises if growth succeeds.
• Potential for higher dividends than in low-geared firms due to leveraged profits.

Risks for investors

• High chance of business failure if repayments cannot be sustained.
• In liquidation, lenders are prioritised over shareholders.
• Shareholders risk losing their full investment if the business collapses.