⚖️ What is Gearing?
Big Idea: The gearing ratio measures the proportion of a business's capital that comes from long-term borrowing compared to total capital employed. It shows how reliant the business is on debt to finance its operations.
Formula: Gearing ratio (%) = (Non-current liabilities / Capital employed) x 100
Where capital employed = non-current liabilities + total equity
- High gearing (above 50%) = more than half the capital comes from debt — HIGH financial risk
- Low gearing (below 25%) = mostly funded by equity — LOW financial risk
- Between 25-50% = moderate gearing — depends on context
Some textbooks use the formula: Non-current liabilities / (Non-current liabilities + Equity) x 100. Others use debt-to-equity ratio = Non-current liabilities / Equity. The IB typically uses the first formula — check the markscheme wording.
📊 Interpreting the Gearing Ratio
High gearing — risks and benefits
- Higher interest payments — reduces profit available for shareholders
- Vulnerable to interest rate rises — costs increase automatically
- Less financial flexibility — harder to borrow more if needed
- Risk of insolvency if profits fall and the business cannot meet repayments
- BUT: interest payments are tax-deductible (cheaper than dividends)
- BUT: owners keep full control (no dilution of ownership)
Low gearing — risks and benefits
- Lower financial risk — fewer fixed interest payments to make
- More attractive to cautious investors and banks
- Greater flexibility to borrow in the future if needed
- BUT: may mean the business is not maximising growth opportunities
- BUT: equity finance (selling shares) dilutes ownership and control
Company A: Non-current liabilities = $300,000. Equity = $700,000. Capital employed = $1,000,000. Gearing = ($300,000 / $1,000,000) x 100 = 30% — moderately geared.
Company B: Non-current liabilities = $600,000. Equity = $400,000. Capital employed = $1,000,000. Gearing = ($600,000 / $1,000,000) x 100 = 60% — highly geared, higher risk.
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🤔 What Affects Gearing Decisions?
- Interest rates — low rates make debt cheaper, encouraging higher gearing
- Business risk — stable, predictable businesses (utilities) can handle higher gearing than volatile businesses (tech startups)
- Growth stage — growing businesses may need more debt to fund expansion
- Asset base — businesses with valuable assets (property, machinery) can use them as collateral for loans
- Industry norms — capital-intensive industries (airlines, manufacturing) tend to have higher gearing
- Owner preference — some owners prefer to retain full control (equity) while others are comfortable with debt
There is no single ''correct'' gearing level. What matters is whether the business can comfortably meet its interest payments from its operating profit. This is the key exam judgement to make.