Whose money built Mill Lane?: To build the Mill Lane bakehouse, Lena's Bakery Ltd borrowed $400,000 from the bank (1.4.3). At the end of 2025, $350,000 of that loan is still owed.
The rest of the long-term money in the bakery belongs to its owners: $200,000 they paid for their shares, and $150,000 of profit kept in the business over the years.
So the bakery's long-term money comes from two places. Money borrowed for more than a year, which must be repaid with interest (non-current liabilities). And the owners' money (equity).
Together they are the capital employed. The question gearing answers is simple: how much of that money is borrowed?
The formula: Gearing ratio = non-current liabilities ÷ capital employed × 100
Capital employed = non-current liabilities + equity. Equity = share capital + retained earnings.
The answer is a percentage. The formula is on the formula sheet you are given in the exam.
Worked example: Lena's Bakery Ltd at 31 December 2025
Find the non-current liabilities
The bank loan: $350,000. The $15,000 overdraft and the $45,000 owed to Valley Grain are current liabilities, due within the year, so they stay out.
Find the equity
Share capital $200,000 + retained earnings $150,000 = $350,000.
Build capital employed
Non-current liabilities $350,000 + equity $350,000 = $700,000.
Divide and multiply by 100
$350,000 ÷ $700,000 × 100 = 50.00%. Two decimal places and a % sign.
What does 50% mean? Half of all the long-term money in the bakery is borrowed. For every $1 the owners have put in or left in, the bank has lent another $1.
Three slips: Counting short-term debts. The overdraft, short-term loans and trade creditors are current liabilities. Only debts due after more than a year go on top of the fraction.
Dividing by equity. $350,000 ÷ $350,000 gives 100%, a different ratio. The bottom of the fraction is capital employed, borrowing plus equity.
Half the equity. Equity is share capital and retained earnings together. Leave out the $150,000 and the answer comes out at 63.64%.
Free preview
This is the free notes preview
You're reading the free notes. Aimnova Pro unlocks the full study experience — and you can try it with your first topic free to keep:
- FlashcardsLock in vocabulary and key terms with spaced repetition.
- Practice questionsAnswer exam-style questions and get instant AI marking.
- Mock exams & past-paper vaultSit full mocks and see exactly how examiners award marks.
- Personalised study planA daily plan built around your exam date and weak areas.
In 2025 Lena's Bakery Ltd paid the bank $10,000 in interest. It paid it before a single dollar of profit reached Lena, Marco or Marco's cousin, and it would have had to pay it in a bad year too. On top of the interest, part of the loan itself is repaid every year.
Why the figure matters: Borrowed money comes with interest and repayments that fall due whatever sales are like. Owners' money does not: in a bad year, no dividend has to be paid.
So the higher the gearing, the more a business must pay out before its owners see anything, and the harder a bad year hits. A business with a high share of borrowing is highly geared; one that runs mostly on its owners' money is low geared.
Highly geared: much of it borrowed
- Payments in good years and bad. Interest and repayments are due even when sales fall.
- Exposed to interest rates. When rates rise, the cost of a variable-rate loan rises straight away.
- Harder to borrow more. A bank sees a large loan already owed and may lend less, or charge more.
- But control stays put. No new shares were sold, and in a good year every dollar of profit above the interest belongs to the owners.
Low geared: mostly owners' money
- A bad year is easier to survive. Little interest to pay, and dividends can simply be cut.
- Room to borrow. A bank will lend readily when a good opportunity comes.
- But owners have paid for it. Their savings, their profit kept back, or shares sold to someone new, who then shares the control and the dividends.
- And growth may be missed. A business that never borrows may pass up a shop or a machine that would have paid for itself.
Is 50% high? As a rough guide, a gearing ratio above 50% is usually called highly geared and one below 25% low geared. Lena's Bakery sits exactly on the line.
As with any ratio, the figure means most next to something else: the same business last year, or similar businesses (3.5.3). A bakery that owns its bakehouse can carry more borrowing than one that rents, because the building can be sold if the worst happens.
Lena's 50%: The $10,000 of interest is small next to the $85,000 of profit before interest and tax, so today the bakery pays it comfortably.
But the $350,000 is still owed, and each new long-term loan pushes the figure above 50%. That is the question behind the Station Road shop.
Practice with real exam questions
Answer exam-style questions and get AI feedback that shows you exactly what examiners want to see in a full-marks response.
The Station Road choice: Lena's Bakery Ltd needs $120,000 to fit out a fourth shop on Station Road (3.2.3). Option 1 is a five-year bank loan at 8%. Option 2 is 400 new shares sold to Farida Rahman, a business angel (3.2.2).
Same money, same shop. Watch what each one does to gearing.
| End of 2025 | Option 1: the loan | Option 2: Farida's shares | |
|---|---|---|---|
| Non-current liabilities | $350,000 | $470,000 | $350,000 |
| Equity | $350,000 | $350,000 | $470,000 |
| Capital employed | $700,000 | $820,000 | $820,000 |
| Gearing ratio | 50.00% | 57.32% | 42.68% |
The loan adds to the borrowed part, so gearing rises. The shares add to the owners' part, so it falls. Every way of changing gearing works like this: to lower it, a business shrinks what it has borrowed or grows what its owners have put in.
Three ways to lower gearing, and what each one costs
Sell new shares
Farida's $120,000 instead of a loan: 42.68% instead of 57.32%.
The cost: Lena's stake falls from 50% to 37.5% of the shares, and a quarter of every future dividend goes to Farida.
Keep more of the profit
Had the bakery paid no dividend in 2025, equity would be $380,000: $350,000 ÷ $730,000 × 100 = 47.95%.
The cost: the owners go without $30,000 (Lena $15,000, Marco $10,000, the cousin $5,000), and it moves the figure slowly.
Repay long-term loans early
Repay $50,000 more of the Mill Lane loan: $300,000 ÷ $650,000 × 100 = 46.15%.
The cost: the cash has to come from somewhere. The bakery holds $25,000, so it would have to sell an asset it no longer needs or save up, and less cash leaves less to pay the bills with (the current ratio, 3.5.2).
Lower is not always better: Improving gearing means moving it to a level the business can carry, not always down. A business with very low gearing and a sure opportunity may do better to borrow: the owners keep control, and the profit above the interest is theirs.
That is why 3.2.3 recommended the loan for Station Road even though gearing rises to 57.32%: the loan ends in five years, the shares would be given away for ever.
The Kestrel Hotel stops paying: The Kestrel Hotel buys rolls and pastries from Lena's Bakery on credit. Two years ago it borrowed heavily to refurbish every room. This winter a road closure kept guests away for four months.
The hotel still owes the bank its repayments, its staff their wages, and Lena $4,000 for three months of rolls. It cannot pay any of them.
The Kestrel Hotel is insolvent: it cannot pay its debts when they fall due, because it does not have the cash. There is a second, stricter meaning too: what the business owes is more than everything it owns is worth.
Insolvency is a state the business is in, not a decision anyone makes. It can still get out of it: a new investor, the sale of an asset, or lenders who agree to wait.
| Insolvency | Bankruptcy | |
|---|---|---|
| What it is | A financial state: the business cannot pay its debts when they are due | A legal process: a court takes charge because the business cannot pay its debts |
| How it starts | Cash runs short, or debts grow bigger than the assets | The business, or someone it owes, asks the court to step in |
| What happens | The owners look for a way out: new finance, selling assets, asking lenders to wait | The court oversees a rescue plan that reschedules the debts, or the sale of everything the business owns (liquidation) |
| How it can end | Solved, if the cash is found in time; if not, bankruptcy | The business trades on under the plan, or it closes and the money from the sale is shared among those it owes |
Heavy borrowing
highly geared
- A large loan for the refurbishment
- Repayments due every month
A bad season
less cash coming in
- The road closes for four months
- Few guests, little cash
Insolvent
cannot pay
- The bank, the staff and Lena go unpaid
- No new money found
Bankrupt
a court takes over
- A rescue plan, or the hotel is sold off
- Those owed money share what is raised
Profitable, and still insolvent: A business can make a profit and still run out of cash. Profit counts a sale when it is made; the bank wants its repayment in cash on the day it is due.
Lena's week three in 1.1.6 was the same problem on a small scale. The more a business has borrowed, the more cash it must find each month, whatever its profit says.
For Lena, the Kestrel Hotel is a debtor that will not pay. If the court sells the hotel, the money raised is shared among everyone it owes, and Lena may get back only part of her $4,000. She now checks how much each wholesale customer owes her before the next delivery goes out.
Feeling unprepared for exams?
Get a clear study plan, practice with real questions, and know exactly where you stand before exam day. No more guessing.
How this comes up: Gearing is calculated from a table of final accounts. Sometimes capital employed is given and one mark needs only the answer. More often you pick the lines out of a list of balance sheet items, for two marks, showing all your working, sometimes straight after building the balance sheet itself.
Then a short explain: how the gearing ratio would change if the business took a new long-term loan, for two marks.
The two-mark calculation
- Write the formula. Gearing ratio = non-current liabilities ÷ capital employed × 100.
- Pick the borrowing. Long-term loans, borrowings and mortgages only. Short-term loans, the overdraft and trade creditors stay out.
- Add up the equity. Share capital + retained earnings (or retained profit).
- Build capital employed. Non-current liabilities + equity.
- Divide, multiply by 100, add the % sign. Two decimal places, rounded correctly.
The traps: Short-term loans in the list. They look like borrowing, but they are due within a year. A table may include them on purpose.
No working, no % sign. One mark is for the working with the right figures in it, one for the answer with its % sign. 16.67% can be written 16.7% or 17%, never 16%.
Using Table 1, calculate Goldcrust plc's gearing ratio for 2025 (show all your working).
Model answer plan
See the mark-by-mark plan — for / against / judgement, with marking guidance — in study mode.