Calculating Gearing
What does gearing measure?
The gearing ratio looks at the relationship between the debts of a firm
and other forms of capital.
Money to pay for a firms assets can come from shareholders, profit retained
by a business, or money borrowed from lenders
When we look at gearing we ask the question;
‘what % of the firms money has come from lenders’?
Why measure gearing?
As we have already said gearing looks at the relationship between the debts
of a firm and other forms of capital. It is useful to know this relationship
because;
• If gearing is low it tells us that the firm has the ability to borrow money to
invest
• If gearing is high it tells us that firm might have difficulty in increasing
borrowings
• If gearing is low then profit will not be used making interest payments
• If gearing is high it could mean a large part of profits are used in paying
interest payments and less profit is available for investment or for
payment of dividends
What figures do we need to measure gearing?
2012
(m)
2011
(M)
247
231
Stock
147
141
Debtors
70
59
Cash and Bank
24
86
Total Current Assets
241
286
Current Liabilities
303
261
Net Current
Liabilities/Assets
(62)
25
Total Assets less Current
Liabilities
185
256
Long-term Liabilities
24
29
Shareholders’ Funds
161
227
Capital Employed
185
256
Fixed Assets
Current Assets
For gearing we use figures
from the firms balance sheet.
The figures we use are
•Long Term Liabilities
•Share holders Capital or Funds
On the account to the left we can see
both Long Term liabilities
and Shareholders Funds
2012
(m)
2011
(M)
Fixed Assets
247
Gearing =
231
The formula we use to
calculate gearing is
Current Assets
Long Term Liabilities (LTL)
Stock
147
141
LTL + Shareholders
Funds
Debtors
70
59
Cash and Bank
24
86
Total Current Assets
241
286
Current Liabilities
303
261
Net Current
Liabilities/Assets
(62)
25
Total Assets less Current
Liabilities
185
256
Long-term Liabilities
29
Shareholders’ Funds
24
161
227
Capital Employed
185
256
+
times
100
1
times
12.9%
= gearing %
100
1
=
Balance Sheets can be presented
in slightly different ways.
In this example from a past paper
question, LTL are shown above
the balancing figure of £1742m,
and Shareholders Capital is
broken down into Share
Capital and Reserves.
But we still use the same figures
and the same formula. So 1773
1773 + 1742
times
100
1
= 50.4%
Of course we could have put in the figures for Share capital (£91m) and Reserves (£1651m)
instead of Total Shareholders Capital – but the answer would be the same
Discussing your answer
So you have calculated gearing, what can you say about your answer?
The firm has a gearing level of just above 50%. This tells us that around half of the firms
capital has been borrowed. 50% is not too high a figure, after all it makes sense
to borrow money to expand, and use profits earned from the expansion
to pay back the loan. If we look at the gearing figure for the previous year,
the result is 40.1%, so there has been quite a jump in borrowing.
This means increased interest payments, but if borrowing has resulted
profitable investments, this should not be a problem.
Fixed Assets
2012
(m)
2011
(M)
247
231
Current Assets
Stock
147
141
Debtors
70
59
Cash and Bank
24
86
Total Current Assets
241
286
Example Question
Analyse the change in the firms gearing over
the two years.
2011
+
Current Liabilities
274
261
Net Current
Liabilities/Assets
(33)
25
Total Assets less Current
Liabilities
214
256
Long-term Liabilities
74
49
140
Reserves
106
34
Capital Employed
214
Shareholders’ Funds
Share Capital
67
256
100
1
= 19.1%
times
100
1
= 34.5%
2012
+
Capital Employed
times