ZIMSEC O Level Business Studies Notes: Business Finance and Accounting: Ratio Analysis: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

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