Business Studies: Gearing ratios

• Gearing refers to the extent to which a business’s assets are financed using debt capital versus equity capital
• Remember the balance sheet equation:
• Assets = Capital (Equity) + Liabilities (Debt)
• What this means is that all assets are purchased using either equity or debt finance
• Equity refers to all the money that belongs (is attributable) to the owners of the business
• It includes capital and retained earnings/ploughed back profit
• Debt finance refers to money attributable to outside parties such as loan from bank, debentures, trade creditors, bank overdraft etc
• So in other words the balance sheet/accounting equation simply expresses the fact that a portion of the business’s assets were bought using money belonging to the owners of the business while another portion was bought using borrowed money
• Gearing is a measure of how much of the assets were bought using equity and how much of the assets were bought using debt finance
• Gearing ratios are also known as debt-equity ratios
• There are various ratios but the most popular is:
• \mathrm{Gearing \quad Ratio = \dfrac{Debt\quad Capital}{Debt\quad Capital+ Equity} x 100}
• Remember debt capital is the same as long term liabilities
• The result is expressed in percentage terms
• For example a business has a capital of $5 000, retained earnings of $ 2 000 and a long term loan of $1 000
• The gearing would be:
• \mathrm{ \dfrac{1000}{1000+ (5000+2000)} x 100}
• 12.5% 
• This means a 12.5% of assets are attributable to debt finance
• If the gearing ratio is high the business is said to be highly geared
• If the ratio is low the business is said to be lowly geared
• A highly geared business has a higher risk of defaulting on its interest and loan payments
• A lowly geared business is missing on some of the opportunities of debt finance

To access more topics go to the O Level Business Notes