How it works
Most businesses operate on some
form of capital gearing (also called
financial leverage). They partly
fund their operations by borrowing
money, via loans and bonds, on the
condition that they make regular
repayments of a fixed amount to
the lender. If the level of gearing is
high (in other words, the business
has taken on large debt), some
investors will be concerned about
its ability to repay and see this as
an insolvency risk. However, if the
amount of operating profit is more
than enough to repay interest, high
gearing can provide better returns
to shareholders. The optimum
level of gearing for a company also
depends on how risky its business
sector is, how heavily geared its
competitors are, and what stage
of its life cycle it is at.
Gearing ratio and
financial risk
Capital gearing is the balance between the capital a
company owns and its funding by short- or long-term
loans. Investors and lenders use it to assess risk.
LONG-TERM DEBT
SHARE CAPITAL +
RESERVES +
LONG-TERM DEBT
$1.2 MILLION
$2 MILLION + $2.455 MILLION +
$1.2 MILLION
21.2%
Low gearing
A software company is going public. Its ratio of 21.2 percent tells
investors that it has relatively low gearing and is well positioned
to weather economic downturns.
Gearing ratio calculation
Analysts and potential investors assess
the financial risk of a company with this
calculation, presented as a percentage.
Pros
Does not have to be repaid
Shareholders absorb loss
Good for start-ups, which may
take a while to become profitable
Angel investors share expertise
Low gearing seen as a measure
of financial strength
Low risk attracts more investors
and boosts credit rating
Cons
Shared ownership, so company
has limited control of decisions
Shared profit in return for
investors risking their funds
Legal obligation to act in the
interests of shareholders
Heavy administrative load
Complex to set up
Equity finance (shares)
Company has
less debt
Company has
more equity
Low proportion of
debt to equity, also
described as a low
degree of financial
leverage. Equity
comes from:
Reserves (retained
profits)
Share capital
Low
gearing
100
100
×
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174 175
High
gearing
HOW FINANCE WORKS
Raising financing
$360 MILLION
$82 MILLION + $120 MILLION +
$360 MILLION
100 64%
Pros
If the company makes a profit,
it can reap a larger proportion
Paying interest is tax deductible
Does not dilute ownership
Company retains control of
decisions
Repayment is a known amount
that can be planned for
Quicker and simpler to set up
Small business loans at favorable
rates may be available to start-ups
Cons
Loan must be repaid
Interest must be paid, even
if operating profit shrinks
Debt may be secured on fixed
assets of company
Unpaid lender can seize assets
and force bankruptcy
Lenders first to be paid in the
event of insolvency
High gearing considered a
measure of financial weakness
High risk may put off investors
and adversely affect credit rating
Debt finance (loans)
Company has
more debt
High proportion of
debt to equity, also
described as a high
degree of financial
leverage. Typical
examples of debt are:
Loans
Bonds
Company has
less equity
High gearing
A water utility is the only water provider in the area, with several
million customers. The ratio of 64 percent is acceptable for a utility
company with a regional monopoly and a good reputation.
Interest cover ratio An
alternative method of calculating
gearing—operating profit divided
by interest payable
Overleveraged A situation in
which a business has too much
debt to meet interest payments
on loans
Deleverage Immediate payment
of any existing debt in order to
reduce gearing
NEED TO KNOW
25%
the ratio at
or below which
a company is
traditionally
said to have
low gearing
× =
US_174-175_Gearing_Ratio_And_Financial_Risk.indd 175 21/11/2014 16:25
174 175
High
gearing
HOW FINANCE WORKS
Raising financing
$360 MILLION
$82 MILLION + $120 MILLION +
$360 MILLION
100 64%
Pros
If the company makes a profit,
it can reap a larger proportion
Paying interest is tax deductible
Does not dilute ownership
Company retains control of
decisions
Repayment is a known amount
that can be planned for
Quicker and simpler to set up
Small business loans at favorable
rates may be available to start-ups
Cons
Loan must be repaid
Interest must be paid, even
if operating profit shrinks
Debt may be secured on fixed
assets of company
Unpaid lender can seize assets
and force bankruptcy
Lenders first to be paid in the
event of insolvency
High gearing considered a
measure of financial weakness
High risk may put off investors
and adversely affect credit rating
Debt finance (loans)
Company has
more debt
High proportion of
debt to equity, also
described as a high
degree of financial
leverage. Typical
examples of debt are:
Loans
Bonds
Company has
less equity
High gearing
A water utility is the only water provider in the area, with several
million customers. The ratio of 64 percent is acceptable for a utility
company with a regional monopoly and a good reputation.
Interest cover ratio An
alternative method of calculating
gearing—operating profit divided
by interest payable
Overleveraged A situation in
which a business has too much
debt to meet interest payments
on loans
Deleverage Immediate payment
of any existing debt in order to
reduce gearing
NEED TO KNOW
25%
the ratio at
or below which
a company is
traditionally
said to have
low gearing
× =
US_174-175_Gearing_Ratio_And_Financial_Risk.indd 175 21/11/2014 16:25
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