Topic list Syllabus reference

Formula to learn
The capital gearing ratio is a measure of the proportion of a company's capital that is debt. It is measured as follows.
. . Interest bearing debt .....
Shareholders equity+mt erest bearing debt
As with the debt ratio, there is no absolute limit to what a gearing ratio ought to be. A company with a gearing ratio of more than 50% is said to be high-geared (whereas low gearing means a gearing ratio of less than 50%). Many companies are high geared, but if a high geared company is becoming increasingly high geared, it is likely to have difficulty in the future when it wants to borrow even more, unless it can also boost its shareholders' capital, either with retained profits or by a new share issue.
Leverage is an alternative term for gearing; the words have the same meaning. Note that leverage (or gearing) can be looked at conversely, by calculating the proportion of total assets financed by equity, and which may be called the equity to assets ratio. It is calculated as follows.


г .. . . .. Shareholders'equity .......
Equity to assets ratio = — x 100%
Shareholders'equity + interest bearing debt
Shareholders'equity
or —- x100%
Total assets less current liabilities
Formula to
learn
In the example of Furlong Co, we find that the company, although having a high debt ratio because of its current liabilities, has a low gearing ratio. It has no preference share capital and its only long-term debt is the 10% loan stock. The equity to assets ratio is therefore high.

		20X8	20X7
Gearing ratio	-	$100,000	$100,000
		$1,009,899	$768,769
		= 10%	= 13%
Equity to assets ratio	=	$909,899	$668,769
		$1,009,899	$768,769
		= 90%	= 87%

As you can see, the equity to assets ratio is the mirror image of gearing.

4. 
   The implications of high or low gearing/leverage
   

We mentioned earlier that gearing or leverage is, amongst other things, an attempt to quantify the degree of risk involved in holding equity shares in a company, risk both in terms of the company's ability to remain in business and in terms of expected ordinary dividends from the company. The problem with a highly geared company is that by definition there is a lot of debt. Debt generally carries a fixed rate of interest (or fixed rate of dividend if in the form of preference shares), hence there is a given (and large) amount to be paid out from profits to holders of debt before arriving at a residue available for distribution to the holders of equity. The riskiness will perhaps become clearer with the aid of an example.