The gearing ratio

There are a number of different gearing ratios accepted which can be laid out differently and using different terminology.  It would be better to check your examining specification and adapt the formula accordingly.  However they work upon a similar basis (although the ideal figure may vary as a result).

                Debt*                   x 100 =  X%

Total Capital (Equity & Debt)

*Debt – is long term liabilities (mortgages / loans) and preference shares.  This is known as serviceable debt as it must be repaid regardless of profit. 

 

Total capital considers all sources of funds.  The key difference is the number of ordinary shares since these do not have to be paid a dividend (although it may be an expectation of the shareholders. Reserves are profits generated – either from normal trading activities (revenue reserves) or one of profits (capital reserves).

Explanation of the gearing ratio: This is the proportion of the overall value of the business which comes from borrowing.  For every £1 the firm is valued at x pence comes from borrowing.  A figure of 40% means 40p in the £1 came from loans.

Compare:  lower the figure may mean it is easier to borrow further monies from the bank.  A 50% figure may sometimes be considered ideal from a risk perspective of the owner.  Banks may not want to put in the vast majority of the money as they want to share the risk with others.  It may be hard to offer secured loans if the non current assets have already been used as collateral. 

Assess: A high figure means it is difficult to borrow (higher risk to the lender) and the debt must be serviced (paying interest or preference share dividends) even if no profit is made. Whereas with the remainder of the capital need not be serviced (reserves, ordinary shares).  However serviceable debt may be preferred to high dividends for ordinary shareholders from the company’s point of view!  It depends on the interest rates and dividend payouts at the time!

Reducing the Gearing ratio can occur by selling shares, repaying loans, increasing reserves  or retaining more profit – this means less debt to be serviced (as a proportion of the value of the business).  Gearing can be increased by taking out further loans.

Relying purely on retained profit may mean growth is slower and firmer may often need to borrow in order to grow fast to maximise an opportunity in the market.