the meaning and importance of gearing

Cambridge A‑Level Business 9609 – Financial Statements, Ratio Analysis & Gearing

Syllabus Checklist for this Lesson

Syllabus Code	Topic	Covered Today
10.1	Financial statements (P&L, balance sheet, cash‑flow, depreciation)	✓
10.2	Analysis of published accounts – all key ratios (liquidity, profitability, efficiency, gearing, investment)	✓ (full focus on gearing, with summary of other ratios)
10.3	Investment appraisal (pay‑back, ARR, NPV) – link to gearing	✓ (link‑in box)
10.4	Finance & accounting strategy – using ratios in strategic decisions	✓
Cross‑topic links	Impact of gearing on HRM, marketing, operations	✓ (case study)

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10.1 Financial Statements – A Quick Refresher

1. Profit & Loss Account (Income Statement)

• Shows revenue, cost of sales, gross profit, operating expenses, interest, tax and the resulting net profit for the period.
• Key line items for ratio analysis: Sales, Gross Profit, Operating Profit (EBIT), Net Profit.

2. Balance Sheet (Statement of Financial Position)

• Snapshot of the firm’s financial position at a specific date.
• Typical headings (Cambridge syllabus):
  • Non‑current assets: property, plant & equipment (PPE), intangible assets, long‑term investments.
  • Current assets: inventories, trade receivables, cash & cash equivalents.
  • Equity: share capital, share premium, retained earnings, other reserves.
  • Non‑current liabilities: long‑term borrowings, deferred tax.
  • Current liabilities: trade payables, short‑term borrowings, tax payable, accrued expenses.
• For gearing calculations we need:
  • Total Debt = short‑term borrowings + long‑term borrowings (interest‑bearing).
  • Total Equity = share capital + retained earnings + other reserves.

3. Statement of Cash Flows

• Divides cash movements into three sections:
  • Operating activities – cash generated from core business.
  • Investing activities – purchase/sale of non‑current assets.
  • Financing activities – borrowing, repayment of debt, issue or buy‑back of shares, dividend payments.
• Useful for assessing a firm’s ability to meet interest and principal repayments – a direct link to gearing risk.

4. Depreciation

• Systematic allocation of the cost of a tangible asset over its useful life.
• Methods covered in the syllabus:
  • Straight‑line – equal charge each year.
  • Reducing‑balance (diminishing‑value) – larger charge in early years.
  • Units‑of‑production – based on actual usage.
• Depreciation reduces the carrying amount of assets on the balance sheet and lowers profit, which in turn affects equity and therefore gearing ratios.

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10.2 Analysis of Published Accounts – Ratio Summary

Ratio Category	Formula	What It Shows	Typical Benchmark	Quick Example
Liquidity	Current Ratio = Current Assets ÷ Current Liabilities	Short‑term ability to meet obligations.	1.5 – 2.0 (industry dependent)	£300 k ÷ £150 k = 2.0
	Quick Ratio = (Current Assets – Inventory) ÷ Current Liabilities	Liquidity excluding stock (which may be slow to convert).	≥ 1.0	(£300 k – £80 k) ÷ £150 k = 1.47
Profitability	Gross Profit Margin = Gross Profit ÷ Sales × 100 %	Efficiency of core production.	30 % – 40 %	£120 k ÷ £400 k = 30 %
	Net Profit Margin = Net Profit ÷ Sales × 100 %	Overall profitability after all expenses.	5 % – 10 %	£25 k ÷ £400 k = 6.25 %
	Return on Capital Employed (ROCE) = Operating Profit ÷ (Equity + Long‑term Debt) × 100 %	Returns generated from capital employed.	≥ 15 %	£45 k ÷ (£800 k + £500 k) = 5.0 % (low)
Efficiency (Activity)	Stock Turnover = Cost of Sales ÷ Average Stock	How quickly inventory is sold.	4 – 8 times per year	£200 k ÷ £30 k = 6.7
	Receivables Turnover = Credit Sales ÷ Average Debtors	Speed of collecting cash from customers.	5 – 10 times per year	£250 k ÷ £40 k = 6.25
	Asset Turnover = Sales ÷ Average Total Assets	Overall use of assets to generate revenue.	1.0 – 2.0	£400 k ÷ £350 k = 1.14
Gearing	Debt‑to‑Equity Ratio = Total Debt ÷ Total Equity	Proportion of financing that is debt‑based.	0.5 – 1.0 (moderate)	£1,200 k ÷ £800 k = 1.5
	Debt‑to‑Capital Ratio = Total Debt ÷ (Total Debt + Total Equity)	Share of total capital that is debt.	≤ 0.50 (moderate)	£1,200 k ÷ (£1,200 k + £800 k) = 0.60
	Interest‑Coverage Ratio = EBIT ÷ Interest Expense	Ability to meet interest payments.	≥ 3.0 (generally safe)	£45 k ÷ £12 k = 3.75
Investment Appraisal	Pay‑back Period = Initial Investment ÷ Annual Cash Inflow	Time taken to recover the outlay.	Usually ≤ 3 years (depends on risk)	£500 k ÷ £200 k = 2.5 years
	Average Rate of Return (ARR) = Average Accounting Profit ÷ Initial Investment × 100 %	Profitability of a project using accounting figures.	≥ 10 %	£70 k ÷ £500 k = 14 %
	Net Present Value (NPV) = Σ (Cash Flowₜ ÷ (1 + r)ᵗ) – Initial Investment	Value added after discounting at the required rate of return (r).	Positive NPV ⇒ accept.	NPV = £120 k (positive) ⇒ go ahead.

Why Ratio Analysis Matters

• Provides a quantitative basis for comparing performance over time and against competitors.
• Helps managers identify strengths, weaknesses and areas requiring corrective action.
• Supplies external stakeholders (investors, lenders, suppliers) with insight into financial health.

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10.2.5 Gearing – Meaning, Calculation & Interpretation

What Is Gearing?

Gearing measures the proportion of a company’s capital that is financed by interest‑bearing debt rather than by shareholders’ equity. It indicates the level of financial leverage and shows how much of the firm’s risk is borne by fixed‑interest obligations.

Key Gearing Formulas

• Debt‑to‑Equity Ratio (DE) \[ \text{DE} = \frac{\text{Total Debt}}{\text{Total Equity}} \]
• Debt‑to‑Capital Ratio (DC) \[ \text{DC} = \frac{\text{Total Debt}}{\text{Total Debt} + \text{Total Equity}} \]
• Interest‑Coverage Ratio (IC) \[ \text{IC} = \frac{\text{EBIT}}{\text{Interest Expense}} \]

DE gives a “per‑£ of equity” view, DC shows the share of total capital that is debt‑based, and IC tests the firm’s ability to meet interest payments – a vital complement to gearing analysis.

Components of “Total Debt” and “Total Equity”

Component	Included in Total Debt?	Included in Total Equity?
Bank loans (short‑term)	Yes	No
Long‑term bonds	Yes	No
Lease liabilities (finance leases)	Yes	No
Trade payables (non‑interest bearing)	No (usually excluded)	No
Share capital	No	Yes
Retained earnings	No	Yes
Revaluation reserves	No	Yes
Preference shares (if interest‑bearing)	Yes (treated as debt)	No

Interpreting Gearing Levels

• Low Gearing – DE < 0.5 (DC < 0.33). Strong equity base, low financial risk, but may indicate under‑utilised borrowing capacity.
• Moderate Gearing – DE ≈ 0.5‑1.0 (DC ≈ 0.33‑0.50). Balanced use of debt and equity; often considered optimal for many industries.
• High Gearing – DE > 1.0 (DC > 0.50). Heavy reliance on debt; higher risk of cash‑flow problems if earnings fall, but potential for higher returns on equity when profits are robust.

There is no universal “good” level – always compare with industry averages, the firm’s historical trend and the stability of its cash flows.

Limitations of Gearing Analysis

• Ignores the actual cost of debt (interest rate) and the firm’s ability to meet interest payments – therefore the interest‑coverage ratio should be examined alongside gearing.
• Does not differentiate between short‑term and long‑term debt; short‑term borrowings are usually riskier.
• Based on accounting values that may be affected by depreciation methods, asset revaluations or off‑balance‑sheet financing.
• Industry‑specific capital structures mean direct comparisons can be misleading.
• Does not reflect non‑interest‑bearing liabilities (e.g., trade payables) which can also affect cash‑flow risk.

Example Calculation – XYZ Ltd.

Year	Total Debt (£)	Total Equity (£)	Debt‑to‑Equity (DE)	Debt‑to‑Capital (DC)	Interest‑Coverage (IC)
2022	1,200,000	800,000	1.5	0.60	3.2
2023	1,000,000	1,000,000	1.0	0.50	4.5

Interpretation

• 2022 – High gearing (DE = 1.5). Lenders may demand a higher interest rate; the firm must monitor cash flow closely despite a marginally acceptable interest‑coverage ratio.
• 2023 – Gearing fell to a moderate level, indicating debt reduction or equity raise. Improved interest‑coverage (4.5) reduces solvency risk and may increase borrowing capacity for future projects.

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10.3 Investment Appraisal – Linking Gearing to Project Decisions

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10.4 Finance & Accounting Strategy – Using Ratios in Decision‑Making

Strategic Applications of Gearing Ratios

• Capital‑Structure Policy – Management may set a target gearing (e.g., DE ≈ 0.8) to balance tax benefits of debt against bankruptcy risk.
• Dividend Policy – Highly geared firms often retain earnings to service debt, resulting in lower dividend payouts.
• Funding Growth & Acquisitions – A low‑geared firm can raise additional debt on favourable terms; a high‑geared firm may need to issue new equity or wait for a stronger cash‑flow position.
• Risk Management – Monitoring gearing together with liquidity (current ratio) and interest‑coverage ratios provides early warning of solvency problems.
• Performance Benchmarking – Compare the firm’s gearing with industry averages and with its own historical trend to assess whether the current capital mix is appropriate.

Cross‑Functional Impact of Gearing

Changes in the firm’s capital structure reverberate through all business areas:

• Operations – Debt finance can fund new plant, increasing capacity and potentially lowering unit costs, but higher interest repayments may constrain working‑capital flexibility.
• Marketing – A strong equity base may support larger promotional budgets or price‑promotion strategies, while high interest commitments can limit marketing spend.
• Human Resources – Stable cash flows from a well‑balanced gearing structure enable recruitment, training and employee benefit programmes; excessive debt may force cost‑cutting and affect morale.

Link to Investment Appraisal (Recap)

When evaluating a new project, incorporate the likely effect on gearing into the appraisal:

1. Estimate the financing mix (debt vs equity).
2. Calculate the post‑investment gearing ratios.
3. Adjust the discount rate in the NPV model to reflect any change in cost of capital.
4. Use the revised NPV, along with pay‑back and ARR, to make an informed go/no‑go decision.

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Key Take‑aways

• Gearing quantifies financial leverage – the higher the ratio, the greater the reliance on debt and the higher the financial risk.
• Calculate both Debt‑to‑Equity and Debt‑to‑Capital to get a complete picture; always check the interest‑coverage ratio as a complementary measure.
• Interpret gearing in context: industry norms, historical trends, and cash‑flow stability matter as much as the raw figure.
• Use gearing analysis when planning capital structure, dividend policy, and especially when assessing the financing of new investments.
• Remember the limitations – accounting conventions, off‑balance‑sheet items and the cost of debt are not captured by gearing alone.