The Gearing Ratio

The Gearing Ratio

This measures the proportion of capital employed (i.e. the value of the business) which is funded by long-term liabilities (i.e. the proportion of the value of the business which is interest-bearing debt). It is calculated using the following formula:

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For example, if a business had long-term liabilities (loans, mortgages and debentures) totalling £3.5 million, and a 'capital employed' figure of £8.3 million, then its gearing ratio would be:

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An answer of more than 50% indicates that the business is 'highly geared', since it has to make large monthly debt repayments. This can become a problem (especially if the economy heads into a recession or the industry goes into decline) because the business will still have to make its monthly repayments, even though its cash inflows may be deteriorating.

A business with a gearing ratio of less than 50% is said to have 'low gearing', since its monthly debt repayments do not form a significant proportion of its monthly outgoings.

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