Gearing (AQA A-Level Business): Revision Notes
Gearing
Gearing is a crucial financial ratio used in business analysis. It reveals where a company obtains its funding and helps investors assess the financial risk associated with a business. Understanding gearing is essential for evaluating a company's financial structure and stability.
What gearing measures
Gearing is a financial ratio that indicates the proportion of a business's funding that comes from non-current liabilities (long-term debt) compared to equity (share capital and reserves). In other words, it shows whether a business relies more heavily on borrowing or on funds provided by shareholders.
The ratio is calculated using information from the lower section of a company's balance sheet, which displays where the business's money originates. This section shows the total amount of finance available to the company, broken down into loans, shares, and reserves.
The balance sheet's lower section is crucial for gearing calculations because it shows both the sources of long-term funding - distinguishing between borrowed funds (non-current liabilities) and owner-invested funds (equity). This distinction is the foundation of understanding a company's financial structure.
Calculating gearing
The gearing formula is:
This calculation produces a percentage that reveals what proportion of the business's total capital comes from long-term borrowing.
Worked Example: Calculating Gearing
A company has the following financial information:
- Non-current liabilities: $400,000
- Total equity: $600,000
Step 1: Identify the values
- Non-current liabilities = $400,000
- Total equity + Non-current liabilities = $600,000 + $400,000 = $1,000,000
Step 2: Apply the formula
Step 3: Interpret the result This 40% gearing indicates standard gearing - the business has a balanced mix of debt and equity financing.
Interpreting gearing percentages
Different gearing percentages indicate different funding structures:
- Above 50%: This is high-geared. More than half of the business's finance comes from long-term debt rather than shareholders' funds.
- 25%-50%: This is fairly standard gearing. The business has a balanced mix of debt and equity financing.
- Below 25%: This is low-geared. Less than a quarter of the finance comes from long-term debt, meaning the business relies primarily on equity funding.
Exam tip: Make sure you can calculate gearing and interpret what different percentages mean for a business's financial structure. You should be able to classify any gearing percentage as high, low, or standard without hesitation.
Gearing and vulnerability to interest rate changes
A business's gearing level directly affects how vulnerable it is to changes in interest rates. The more a business borrows, the more severely it will be affected when interest rates rise, because it must pay more interest on its loans.
The amount a business can safely borrow depends on its profitability and the value of its assets. Businesses with more valuable assets can offer them as security (collateral), making it easier to borrow larger amounts. Assets provide lenders with reassurance that they can recover their money if the business fails to repay.
The relationship between assets and borrowing capacity is straightforward: valuable assets increase borrowing power because they serve as collateral. If a business owns substantial property, equipment, or other assets, lenders are more willing to provide loans since they can seize these assets if repayments aren't made.
Gearing as a risk assessment tool
Investors use gearing as a risk assessment indicator when deciding whether to purchase shares in a company. Higher borrowing means the business must pay more interest, which can reduce profits and the dividends paid to shareholders. Conversely, the more a firm borrows, the greater the risk that investors won't receive substantial dividends, as profits may be consumed by interest payments.
Worked Example: Low-geared business (11%)
Consider a firm with gearing of 11%:
- This indicates that most of the long-term funding comes from shareholders rather than borrowing.
- The business is risk averse, meaning it prefers to avoid the risk of high interest payments.
- Being low-geared allows the firm to withstand a fall in profits more easily than a highly geared competitor. Since the company doesn't have significant interest payment obligations, it can choose to reduce dividend payments to shareholders rather than defaulting on loan repayments.
- This financial flexibility gives the business greater stability during difficult trading periods.
Worked Example: High-geared business (72%)
Now consider a firm with gearing of 72%:
- This shows that most of the long-term funds come from borrowing rather than equity.
- The firm is clearly willing to take risks. If profits decline or interest rates rise, the business must still maintain loan repayments, which could result in losing the assets used as security for the loans (such as business premises).
- The company may be high-geared to fund growth and expansion plans.
- Alternatively, directors may wish to retain ownership control and prefer borrowing over selling shares to outside investors, which would dilute their ownership stake.
Exam tip: When analysing gearing, always consider the context – why might a business choose high or low gearing? What are the implications for different stakeholders? Context is crucial for demonstrating analytical thinking in your answers.
Risks and rewards of high gearing for businesses
High gearing can be risky, but businesses may accept these risks because of the potential rewards.
Rewards of high gearing
Borrowing money offers several potential benefits:
- Extra funds for expansion: Loans provide capital that can be invested in new projects or technology. Ideally, these investments increase profits by more than enough to cover the loan repayments and interest charges.
- Attractive during growth phases: A firm establishing itself as a market leader with growing profits and a strong product portfolio may borrow heavily to fund expansion and gain a competitive advantage.
- Increased gearing during growth: When the business is growing, there may be plenty of profit remaining even after loan interest and repayments, making high gearing beneficial.
- Lower risk when interest rates are low: High gearing becomes less risky when interest rates are very low, because interest payments are more manageable.
The key principle behind high gearing as a growth strategy is leverage - using borrowed money to generate returns that exceed the cost of borrowing. If a business can invest borrowed funds in projects that return 15% while paying only 5% interest, the difference represents additional profit that wouldn't exist without borrowing.
Risks of high gearing
High borrowing also carries significant risks:
- Inability to afford repayments: The primary risk is that the business might not generate sufficient profit to repay the loan and interest. This could lead to financial difficulties or even business failure.
- Commitment to repayments regardless of circumstances: Even when interest rates are low initially, they may rise later. The business remains committed to making repayments regardless of economic conditions or changes in interest rates.
Unlike dividends, which businesses can choose to reduce or skip during difficult times, loan repayments are mandatory. This inflexibility is the fundamental risk of high gearing - businesses must meet their debt obligations even when profits fall, potentially leading to liquidation if they cannot pay.
Risks and rewards of high gearing for investors
High gearing affects not only businesses but also the investors who provide capital.
Rewards for investors
Investors may benefit from high gearing in several ways:
- Interest or dividends: Lenders receive interest payments, while shareholders receive dividend payments (typically once per year).
- Share price appreciation: Shareholders can sell their shares at a profit if the share price increases.
- Higher returns from high-geared businesses: Since high gearing can lead to higher profits for successful businesses, shareholders might expect larger dividends and a bigger increase in share price compared to investing in a low-geared company.
Risks for investors
However, high gearing also creates risks for investors:
- Risk of business failure: The main risk for shareholders is that the business may fail if it cannot keep up with loan repayments.
- Loss of investment: If a business enters liquidation (goes bust), lenders will probably recover the money they're owed (as they have security), but shareholders could lose most or all of the money they've invested in the business.
Priority in liquidation matters: In the event of business failure, there's a clear hierarchy for repayment. Lenders with secured loans are paid first from the sale of assets, while shareholders are last in line. This makes equity investment in high-geared businesses particularly risky - shareholders face the highest risk of total loss if the business fails.
Exam tip: Consider both perspectives – businesses and investors – when evaluating the impact of gearing decisions. Different stakeholders face different risks and rewards. Strong exam answers demonstrate understanding of multiple stakeholder viewpoints.
Using Gearing in Exam Questions
When answering questions about gearing, remember to:
- Calculate accurately: Use the formula correctly and show your working.
- Interpret the result: Explain whether the gearing is high, low, or standard.
- Consider context: Think about why the business has this gearing level and what it means for the company's strategy.
- Analyse impacts: Discuss the implications for different stakeholders (owners, shareholders, lenders).
- Make judgements: Evaluate whether the gearing level is appropriate given the business's circumstances, such as economic conditions, industry norms, and growth plans.
Key Points to Remember
- Gearing shows the proportion of a business's finance that comes from non-current liabilities (long-term debt) rather than equity.
- The gearing formula is:
- High gearing (above 50%) means more than half of finance comes from borrowing; low gearing (below 25%) means less than a quarter comes from debt.
- High gearing increases vulnerability to interest rate changes and makes the business riskier, but it can fund expansion and increase profits.
- For investors, high gearing can lead to higher dividends and share price growth, but also carries the risk of losing their investment if the business fails.