7.2f - Ratios (Gearing)

Question 1

What are the two main sources of capital?

Answer 1

• Retained profit

- Borrowings

Question 2

Gearing definition

Answer 2

The proportion of the business’ capital employed that has been bought using long-term borrowings

Question 3

Is lower or higher gearing better?

Answer 3

Lower

Question 4

Gearing formula

Answer 4

(Long-term liabilities / capital employed) X 100

Question 5

Advantages of high gearing:

Answer 5

• Borrowing can be cheap
• If ROCE is high business could borrow to invest
• Fewer shareholders so less loss of control

Question 6

Disadvantages of high gearing:

Answer 6

• May not be able to afford repayments, especially if interest rates rise
• It is less likely that potential investors will buy shares as it means business has to pay more interest which could affect profit

Question 7

Advantages of low gearing:

Answer 7

• Reduces risk of business downturn

- Borrow more/quicker

Question 8

Advantages of reducing gearing:

Answer 8

• Focus on profit improvement
• Repay long-term loans
• Issue more shares
• Convert loans into equity

Question 9

Advantages of increasing gearing:

Answer 9

• Focus on growth
• Convert short-term debt into long-term loans
• Buy back ordinary shares
• Pay increased dividends to shareholders