Revision:Gearing - Formula and uses

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Gearing

What is Gearing

Gearing is a tool that is used by investors and businesses to show how much of the long term finance came from loans and how much came from shareholder funds. It also shows how exposed the firm is to financial risk. To see this we can look at the Gearing formula.

Gearing Ratio

The Gearing Ratio looks at the level of borrowing that a company has taken on in the form of loans and compares that to the total long term finance that a business has.

Long Term Liabilities: this figure is how much loans the business has.

Capital Employed: this is the total level of finance that a business has in the long term. It can be shown as the Shareholder funds + Long term liabilities.

As a ratio, we obtain a percentage figure from the formula. Since the formula shows the ratio of Loans to (shareholder funds + Loans), the percentage obtained tells us a few things.

High Gearing - where a high % of the long term finance is in the form of loans. A high percentage is a figure that is over 50%.

Low Gearing - where a low % of the long term finance is in the form of loans. A low percentage is a figure that is between 0% and 50%

What Does the Gearing Figure mean for the Business and Shareholders?

Gearing shows a firms exposure to financial risk. A high gearing percentage tells us that the firm has a high level of loans compared to shareholder funds. The high level of loans also means that the firm has to pay a higher interest charge. This means that if profits were low, or did not meet predicted levels then the firm would have a tough time paying off the interest charges, which would affect other areas of the firm e.g. a lower investment into Research & Development for a year. So the greater the gearing percentage the greater the exposure to risk, and the risk of interest rate rises.

For shareholders and potential investors the gearing level is important, and as such it is a very important tool when analysing whether a business is a viable investment:

• Potential investors view firms that are highly geared as being a risky investment
• Higher gearing raises the exposure to interest rate changes, so investors will be put off investing if they feel that interest rates will rise
• Higher gearing means that the company will be in risk of liquidation if it cannot meet interest payments
• Investors looking to give a loan to the company will also look at the gearing ratio
  • A highly geared company will already be paying high interest charges, so investors will be put off from give it a further loan as the firm may not be able to pay it back
  • A low geared firm is more likely to get a loan from investors since its loan payments are low, and its exposure to risk is also low

Advantages and Disadvantages of High Gearing

Here are some Advantages and Disadvantages of High Gearing

Advantages of High Gearing

• Borrowing may allow the firm to take on profitable projects
• Taking on more profitable projects may allow the comapny to expand and in the future reduce its Gearing ratio
• Borrowing may be a quick and cheap form of financing a project compared to other means such as share issues which may not all be taken up

Disadvantages of High Gearing

• If the company has low profits then it may struggle to meet interest payments, leading to a higher risk of being liquidated
• The firm may find it harder to get further loans, since investors will be put off by the high gearing level

Advantages and Disadvantages of Low Gearing

Advantages of Low Gearing

• Changes in interest rates especially upward trends have a lower effect on the firm
• Less risk of liquidation occuring due to not being able to pay off interest payments
• Reduced Interest payments, so more investment can occur elsewhere and the firm can have more cash flow to take on bigger and potentially more profitable projects

Disadvantages of Low Gearing

• The firm is expected to make regular dividend payments
• The higher ratio of Shareholder funds will mean that the company will now be owned by its shareholders more relatively

Comments

• the subject the are for= Business Studies
• the topic area they fall in to within that subject = Accounting and Finance
• the exam board and specification they are for = AQA mainly but this is also in the syllabus for many other boards too
• which module or exam level they are relevant for = Unit 4/BUS4 AQA

--Thetopnotch 13:11, 17 April 2009 (BST)