9609 · 10.2.4
Gearing ratio — FAQ
Frequently asked questions for 9609 Gearing ratio. Direct answers first, then deeper explanation — then practise with marking.
Is a high gearing ratio always a negative sign for a business?
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.
How can a company actively reduce its gearing ratio?
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.
Does the gearing ratio include short-term debts like a bank overdraft?
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.