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Gearing

Measures the extent to which a business is dependent on borrowed funds and its financial stability. It is most commonly calculated by dividing long-term debt (liabilities) (or non-current liabilities) by the total capital employed in a business ie total equity plus non-current liabilities (or owners / shareholders equity + long-term debt finance) and multiplying by 100 to give a percentage. The more capital raised on borrowed funds, the more highly geared a business is. Example, if a company’s non-current liabilities amounted to £300,000, share capital amounted to £700,000, and reserves and retained earnings amounted to £200,000 (ie total equity amounted to £900,000), the company’s gearing ratio would be 25% (£300,000 / £1,200,000 X 100). There are other ways of calculate gearing: Total liabilities / Equity plus total liabilities x 100; long-term debt / Equity x 100. Consequently, when making comparisons between businesses it is important to ensure that the same formula is / has been used. In general, if long-term loans represent more than 50% of total capital employed, then the firm is said to be highly geared. The higher the gearing, the higher the risk. This is because: the business is committed to meeting interest payments, which has a negative effect on cash flow and net profit; loans are often secured on a business’s fixed assets and if the business cannot meet the interest payments then the lender has the right to claim the asset on which the loan is secured; debtors have priority over owners / shareholders if the business fails. Before taking out a loan, a business should therefore, be certain that the rate of return on assets / projects financed by borrowing, exceeds the cost of financing (eg through the use of investment appraisal techniques). On the other hand, one could argue that the risk to the individual owner / shareholder is lower, and the potential reward is greater. This is because it provides an opportunity for a greater return to owners / shareholders without the need to provide a greater amount of capital. In other words they are risking someone else’s money. Debt is also normally cheaper than equity because it is tax deductible.

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