7.2f Ratios - Gearing

Question 1

What are the two main sources of capital/funds?

Answer 1

• Start-up capital/retained profit

- Borrowings

Question 2

What does gearing show?

Answer 2

The proportion of the business’ capital employed that has been bought/built using long term borrowings

Question 3

Is lower or higher gearing usually better?

Answer 3

Lower

Question 4

What does gearing focus on?

Answer 4

Long-term financial stability of the business

Question 5

What do you need to look out for in gearing?

Answer 5

Increased gearing and deterioration in other liquidity/financial efficiency rations

Question 6

Gearing formula

Answer 6

Gearing (%) = (long term liabilities ÷ capital employed) x 100

Question 7

Over 50% in the gearing formula means what?

Answer 7

Highly geared

Question 8

Below 50% in the gearing formula means what?

Answer 8

Lowly geared

Question 9

What does it mean if a business is highly geared?

Answer 9

A high proportion of the organisation’s funds have been borrowed externally

Question 10

Advantages of high gearing

Answer 10

• Borrowing can be cheap
• If ROCE is high, could borrow to invest/spend
• Fewer shareholders so less loss of control
• Gain a competitive advantage by borrowing extra funds for growth

Question 11

Advantages of low gearing

Answer 11

• Reduces risk of business downturn

- Borrow more/quicker

Question 12

Implements of reducing gearing

Answer 12

• Focus on profit improvement
• Repay long-term loans
• Retain profits

Question 13

Implements of increasing gearing

Answer 13

• Focus on growth
• Convert short-term debt into long-term loans
• buy back ordinary shares

Question 14

Disadvantages of high gearing:

Answer 14

• Less likely potential investors will buy shares as business need to pay interest before dividends
• May not be able to afford repayments if interest rates rise