Business Finance - Gearing

Revision notes on Gearing for A2 Business Studies

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  • Created on: 25-03-08 16:29
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Business Lindsay Emma Rudd BMA
Gearing
Gearing measures the long term liquidity of a business. Under some classifications gearing
is included as a liquidity ratio. There are a number of methods of measuring gearing we
shall consider the simplest form of the ratio. This ratio analyses how firms have raised their
long term capital. The result of this calculation is expressed as a percentage.
There are two main forms of long term finance available to businesses.
1. Longterm borrowing. This includes preference shares and debentures (all have
fixed interest payments). This is called loan capital
2. Equity capital from selling ordinary shares.
Total capital employed (or capital employed) is simply the total of these two. So this gearing
ratio measures the percentage of a firm's capital that is borrowed.
Gearing = Longterm Loans
Total capital employed
This measure of a businesses performance is important because by rising too high a
proportion of capital through fixed interest capital firms become vulnerable to increases in
interest rates. Shareholders are also unlikely to be attracted to a business with a high
gearing ratio as their returns might be lower because of the high level of interest payments
to which the company is already committed.
A highly geared business has more than 50% of its capital employed in the form of
loans.
A low geared business has less longterm borrowing and a gearing figure below 50%
Much attention tends to be given to businesses that have high gearing and a vulnerable to
increases in interest rates. However this may be considered acceptable in a business that is
growing quickly and generating high profits. Furthermore, a lowgeared business may be
considered to be too cautious and not expanding as quickly as possible.
Using this ratio
The key yardstick is whether a business's long term borrowing is more than 50% of their
capital employed.
Companies with secure cash flows may raise more loan capital because they are
confident of being able to meet interest payments. Equally a business with well known
brands may be able to borrow heavily against these brands to increase longterm
borrowing.
Firms can improve their gearing by repaying longterm loans, issuing more ordinary
shares or redeeming debentures.

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