Question 1

Is a high gearing ratio always a negative sign for a business?

Accepted Answer

Not necessarily. While it signifies higher risk, using debt (leverage) can be a deliberate strategy to fund growth. If the business earns a higher return on its investments than the interest rate it pays on its loans, shareholder returns are magnified. For companies in stable industries with predictable cash flows, a higher gearing level can be sustainable and beneficial for maximising shareholder value.

Question 2

How can a company actively reduce its gearing ratio?

Accepted Answer

A company can lower its gearing by either reducing its long-term debt or increasing its equity. Common methods include: 1. Repaying long-term loans ahead of schedule. 2. Issuing new shares to raise fresh equity capital. 3. Retaining a higher proportion of profits instead of paying them as dividends, which builds up the equity base over time. 4. Selling non-essential assets to generate cash for debt repayment.

Question 3

Does the gearing ratio include short-term debts like a bank overdraft?

Accepted Answer

No, the standard gearing ratio formula specifically uses non-current liabilities, which are long-term debts. It is designed to assess the long-term capital structure of the business. Short-term debts like overdrafts and trade payables are part of working capital and are analysed using liquidity ratios, such as the current ratio and acid test ratio.

Gearing ratio

What you need to know

Gearing ratio