The meaning and formula for gearing ratio

Gearing ratio assesses the extent to which a business funds its operations through borrowed money rather than its own capital. While loans can support growth by financing expansions that may boost profits, they also heighten the overall risk to the business due to repayment obligations.

$\text{Gearing ratio}=\frac{\text{non-current liabilities}}{\text{capital employed}}\times 100$

Where:

• Non-current liabilities = Long-term debts, such as bank loans (£)
• Capital employed = Total long-term finance, including shareholders' equity and non-current liabilities (£)

A gearing ratio above 50% signals that the business is highly geared, meaning it relies heavily on debt, which can become problematic if earnings drop sharply.

Worked example - Calculating gearing ratio

A company has non-current liabilities of £300,000 and capital employed of £900,000. Calculate the gearing ratio and interpret the result.

Step 1: Identify the values

• Non-current liabilities = £300,000
• Capital employed = £900,000

Step 2: Apply the formula

$\text{Gearing ratio}=\frac{\pounds \mathrm{300,000}}{\pounds \mathrm{900,000}}\times 100$

Step 3: Perform the calculation

$\text{Gearing ratio}=0.333\times 100=33.3\%$

Step 4: Interpretation

A gearing ratio of 33.3% indicates low gearing, suggesting the business is not heavily reliant on debt and may adopt a safer financial strategy.

The risks associated with high gearing

High gearing exposes a business to greater financial vulnerability, particularly in times of reduced profitability, as it struggles to meet debt-related commitments.

Key risks of high gearing

• Inability to service debts - Substantial loans mean higher interest payments, which must be met regardless of profit levels, potentially leading to default if earnings decline.
• Impact on shareholders - Elevated debt levels reduce funds available for dividends and retained earnings, as interest takes priority.
• Liquidity challenges - Debts eventually require repayment, which can strain cash reserves and limit the business's ability to cover short-term obligations.
• Overall business risk - In severe cases, failure to repay loans or interest could result in insolvency, especially during economic downturns.

The implications of low gearing

Low gearing reflects a conservative approach to financing, where a business minimises debt to reduce exposure to financial pressures.

Characteristics of low gearing

• Safer financial position - With less reliance on borrowing, the business faces lower risk of default and can more easily manage interest payments during profit fluctuations.
• Potential drawbacks for growth - Management might be overlooking opportunities to borrow for investments or expansions, leading to slower development.
• Effects on shareholder returns - Investors may experience more gradual increases in dividends or share value compared to those in successfully managed high-gearing firms, as the business grows at a steadier but less aggressive pace.

Methods to improve gearing and their drawbacks

Improving gearing involves strategies to decrease dependence on debt, thereby lowering the gearing ratio. However, each method carries potential limitations that businesses must consider.

Strategies for reducing gearing

• Issuing more shares to repay loans:
  • This raises equity finance to clear debts.
  • Drawbacks:
    • Dilutes control for existing shareholders as ownership is spread wider.
    • Increases the need for higher dividend payouts to satisfy more investors.
    • May result in low share prices if sold during unfavourable market conditions.
• Cutting dividends to retain more profits:
  • Retained earnings can be used to pay off loans over time.
  • Limitations:
    • Only effective if profits are sufficient to cover repayments.
    • Reduces immediate returns for shareholders, potentially causing dissatisfaction.
• Selling assets to generate funds:
  • Assets like property or equipment can be liquidated to settle debts.
  • Challenges:
    • Quick sales often fetch lower prices, leading to financial losses.
    • Reduces the business's overall value and limits future expansion potential.