GEARING Flashcards
What is the definition and formula for “gearing”
Measures the financial health of a company by calculating the proportion of the company financed by long term debt.
= Non - current liabilities / total equity + non current liabilities
What are you measuring
What you’re measuring is risk - To judge how risky a company is to identify the proportion of that company that has been financed by long term debt. In other words, the amount of money that’s been invested into that company, how much of that has been borrowed from outside sources like a bank and therefore need to be paid back - That’s what you’re measuring with this ratio.
What are liabilities
Liabilities: Debts that a business owes, and is going to have to repay
What are current liabilities
Current liabilities: Debts that need to be paid for in the next 12 months
What are non current liabilities
Non - current liabilities: Debts that are due in over 12 months - long term loans like bank loans and mortgages.
Lond term debts (bank loans etc)
What is total equity
Total equity: Value of shareholders’ funds
Value fo shareholders’ funds
What is total capacity employed
Total capital employed: The total amount that has been invested
What are net assets
Net worth of a businesses assets and liabilities
What is share capital
Money invested by shareholders
What are “reserves and retained profit”
Cumulative value of retained profit
What are some key thing that are required to have in order for this to be beneficial
Any company with a gearing ratio over 50% is said to be ‘highly geared’
Being highly geared is considered risky as interest rates will have to be paid before profits can be distributed to shareholders or reinvested in the company - If you’ve funded your business through shareholders, then you’re not legally required to pay the funding back in the form of dividends.
A high geared company with low liquidity would be considered especially risky - The solution to low liquidity would be to get a lone, but they company probably won’t be able to get a loan as they are highly geared
Low gearing (less than 25%) can be a sign of a lack of ambition (in other words, why is the company not borrowing money to invest, do they managers not feel confident enough in their product or service, that they won’t be able to pay the money back) - would it be better to borrow some money and expand?
What are benefits of low gearing
Indicates company is financed by shareholders - dividend payments are optional
Companies not a risk as companies are in less danger of not being able to meet repayments
Tends to be considered lower risk as companies are in less danger of not being able to meet repayments
How can you increase gearing in a company
Focus on growth (revenue, expansion) rather than profits
Take sensible risks
Borrow money to cover short term debts
Buy back ordinary shares
How can you reduce gearing in a company
Repay loans
Issue more ordinary shares
Retain profits to pay off debt rather than paying dividends
