gearing ratio

System
System Posts: 100,534 🤖 Admin 🤖
edited 10:08AM in AAT student discussion
can someone please explain the gearing ratio. thanks

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  • System
    System Posts: 100,534 🤖 Admin 🤖
    gearing ratio

    Millitread,<BR><BR>Gearing = Long Term Liabilities / Equity Shareholders' Funds <BR><BR><BR>Gearing is concerned with the relationship between the long terms liabilities that a business has and its capital employed. Ideally, the shareholders' funds should be significantly larger than the long term liabilities.<BR><BR>So for example,<BR><BR>LTL 850000 / ESF 6000000 = 0.14 or 14%<BR><BR>The lower the gearing ratio the better. A higher gearing ratio will indicate that a business is using debt funding for long term projects as opposed to equity funding. You still have to pay interest on LTL (which are generally in the form of loans) whereas with Shareholders funds you do not have to pay dividends in poor years.<BR><BR>Hope this helps<BR><BR>Eddy B<BR><BR>
  • System
    System Posts: 100,534 🤖 Admin 🤖
    gearing ratio

    To think of gearing simply try to think of it like a mortgage on a house. Long term debt, i.e. you want to pay your loan off over a period of about 25 years.<BR><BR>If you have high gearing, high debt that could be like having a high mortgage, imagine a 100% or 95% mortgage. Your payments would be bigger, so more risky as if you have any problems you are more likely to default. If you want to borrow more money, finance companies may not be willing to lend you any more as you have no equity - just like in a company.<BR><BR>If you have a small mortgage, things are a lot safer, so payments are lower, less risk of default, more chance of future finance.<BR><BR>Hope this helps<BR><BR>Lisa
  • System
    System Posts: 100,534 🤖 Admin 🤖
    gearing ratio

    thanks much I am getting there, thanks to you all.
  • System
    System Posts: 100,534 🤖 Admin 🤖
    gearing ratio

    I'm interested that you say low gearing is better. If a company fails to pay a dividend it would be a clear signal to investors that there is an ongoing problem. This would cause many risk averse shareholders to sell their shares. This, in turn, would cause the share price to drop, the result of which may be to undervalue the company and make it a potential takeover target. Think of the effect on confidence if M&S said, no dividends this year!<BR><BR>Modigliani and Miller demonstrated that, in the presence of corporation tax, the weighted average cost of capital of a company falls as gearing increases, due to the company getting tax relief on interest payments ( called the Tax Shield). Thus many companies prefer to finance via long term debt rather than dilute current share capital.<BR><BR>Also bear in mind that there are several versio ns of the gearing calculation: including long term debt/(equity funds+long term debt).<BR><BR>

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