methods of improving gearing

10.2 Analysis of Published Accounts – Gearing Ratio 📊

What is the Gearing Ratio?

The gearing ratio tells us how much of a company’s capital comes from borrowing compared to its own funds. It’s a quick way to gauge financial risk.

ComponentFormula
Long‑term DebtTotal debt that is due in more than one year
EquityShareholders’ equity + retained earnings
Gearing Ratio\$ \displaystyle \frac{Long\text{-}term\ Debt}{Equity} \$

Analogy: Think of a company’s capital like a pizza. The slice of debt is the “cheese” (borrowed money) and the slice of equity is the “crust” (own money). A higher cheese slice means the pizza is more “cheesy” – riskier!

Interpreting the Ratio

  1. Low Gearing (e.g., < 0.5): The company relies more on its own money – safer but may miss growth opportunities.

  2. Moderate Gearing (≈ 0.5–1.0): Balanced use of debt and equity – common for many businesses.

  3. High Gearing (> 1.0): More debt than equity – higher risk of default, but can boost returns if profits rise.

How to Improve Gearing (Lower the Ratio)

  • 🔧 Reduce Debt: Pay down loans or refinance at lower rates.

  • 💰 Increase Equity: Issue new shares or retain more earnings.

  • 📈 Boost Profitability: Higher profits increase equity without extra debt.

  • 🧩 Re‑structure Capital: Convert short‑term debt to long‑term or swap debt for equity.

  • 📉 Control Costs: Lower operating expenses to free up cash for debt repayment.

Exam Tip: When asked to improve gearing, list at least two methods and explain the impact on the ratio. Use the formula to show the change numerically if possible.

Example Calculation

Suppose a company has:

  • Long‑term debt = £200,000

  • Equity = £400,000

Gearing Ratio = \$ \displaystyle \frac{200,000}{400,000} = 0.5 \$ – a moderate level.

If the company pays off £50,000 of debt and retains £30,000 of earnings:

  • New debt = £150,000

  • New equity = £430,000

New Gearing Ratio = \$ \displaystyle \frac{150,000}{430,000} \approx 0.35 \$ – the company is now less leveraged.

Quick Summary Box

Gearing Ratio = \$ \displaystyle \frac{Long\text{-}term\ Debt}{Equity} \$

Lower ratio = less risk, higher safety.

Higher ratio = more risk, potential for higher returns.

Use the methods above to lower the ratio when required.