Gearing ratios

Gearing is the proportion of a firm's long-term capital that is financed by debt (non-current liabilities) (1) rather than by shareholders' funds (1) — it is a measure of the firm's reliance on borrowing and its financial risk.

High gearing means the business relies heavily on debt finance, so it must pay large amounts of interest whatever its level of profit. Because interest is a fixed commitment, in a year when profits fall — or if interest rates rise — the interest can swallow most of the profit, leaving little for shareholders and possibly threatening the firm's survival. The firm may also find it harder to borrow more, as lenders see it as a greater credit risk. This is why high gearing raises financial risk.

One way is to issue more shares. Selling new ordinary shares raises shareholders' funds, increasing capital employed without adding any debt, so the debt proportion — and therefore gearing — falls. This reduces the interest burden, though it dilutes existing owners' control.

A second way is to repay long-term debt using the firm's cash. Paying off loans directly reduces non-current liabilities, lowering gearing and cutting future interest costs. The drawback is that it uses up cash the firm might need elsewhere, and there may be early-repayment charges.

Both methods shift the balance of finance away from debt towards equity, reducing financial risk — though the better choice depends on the firm's cash position and its shareholders' attitude to issuing new shares.

High gearing — relying heavily on debt — has both benefits and dangers.

Advantages. Because interest is a fixed cost and the firm has raised finance through debt rather than issuing new shares, profit (after interest) is shared among fewer shares, so earnings per share can be higher. In good times, as profits grow while interest stays fixed, a larger share of the extra profit flows to shareholders — high gearing magnifies returns. Using debt also avoids diluting existing owners' control, and debt finance can be raised relatively quickly to fund expansion.

Disadvantages. The firm faces a heavy interest burden that must be paid whatever its profit. In a downturn, or if interest rates rise, interest can swallow most of the profit, leaving little for shareholders and threatening survival — so returns become volatile. Lenders may also be reluctant to lend more, limiting future finance, and the firm has less flexibility because the loan must eventually be repaid.

Judgement. High gearing therefore magnifies outcomes — boosting returns in good times but increasing risk in bad. It suits a firm with stable, predictable profits that can comfortably cover interest, but is dangerous for a firm with volatile profits. So whether high gearing is an advantage depends on the stability of the firm's profits and the interest-rate environment.

The company can fund expansion with debt (a long-term loan, raising gearing) or equity (a share issue, keeping gearing low). The right choice depends on the firm's profit stability, the cost of each source and its shareholders.

The case for a long-term loan (raising gearing). Because the company is already low-geared and profitable, it has room to take on debt without becoming dangerously risky. Debt would avoid diluting existing shareholders' control and ownership, and — since interest is a fixed cost — if the expansion succeeds, the extra profit (after a fixed interest charge) would be shared among the same number of shares, boosting earnings per share. Interest is also tax-allowable and a loan can usually be arranged faster than a share issue. For a firm with stable, predictable profits, sensible borrowing exploits cheap debt to magnify returns.

The case for a share issue (keeping gearing low). A share issue brings in finance with no obligation to pay interest or repay capital, so it adds no financial risk — important if the expansion's returns are uncertain or if profits could prove volatile. It keeps the firm resilient to a downturn or rising interest rates, and preserves borrowing capacity for the future. The drawbacks are that it dilutes control and spreads dividends more widely, it can be slow and costly to arrange, and it depends on investors being willing to buy.

Judgement (criterion). The decision depends mainly on how stable and predictable the company's profits are, and how much risk it and its shareholders are willing to accept. Given that the firm is profitable and currently low-geared, it can afford to raise some debt and benefit from the boost to returns, provided its profits are stable enough to cover the interest comfortably — moving gearing up from a low base towards a moderate level is not reckless. However, if the expansion's returns are uncertain or profits are cyclical, a share issue (or a blend of the two) is safer. On balance, for a stable, profitable, low-geared firm, a long-term loan is likely the better single choice because it exploits the firm's spare debt capacity and rewards shareholders — but only up to the point where gearing remains comfortably manageable; otherwise equity, or a combination, should be used.

Keeping gearing low means financing the business mainly from shareholders' funds rather than debt, which reduces financial risk. But whether a business should always aim for low gearing depends on its profits, its growth opportunities and the cost of finance.

The case for keeping gearing low. Low gearing makes a business safer and more resilient. With only a small interest commitment, the firm can survive a fall in profits or a rise in interest rates that would cripple a highly geared rival, because little of its profit is pre-committed to interest. It also keeps the firm attractive to lenders, preserving the ability to borrow when it really needs to, and avoids the danger that debt repayments force a fundamentally sound business into insolvency. For a firm with volatile or unpredictable profits — a cyclical manufacturer, a start-up, or a business in a fast-changing market — low gearing is clearly sensible, because it cannot rely on always covering interest.

The case against always keeping gearing low. Low gearing can mean the firm is failing to exploit cheap debt to grow. Debt is often a cheaper source of finance than equity (interest is tax-allowable and lenders accept a lower return than shareholders expect), and because interest is fixed, higher gearing can magnify the returns to shareholders in good times — raising earnings per share. Relying too heavily on equity also dilutes existing owners' control and spreads dividends more widely. A firm with stable, predictable profits (such as a utility) can comfortably carry high gearing and reward its shareholders by doing so — so insisting on low gearing would waste an opportunity and could leave the firm growing more slowly than better-financed competitors.

Weighing it up (criterion). The right level of gearing depends above all on the stability and predictability of the firm's profits, and on its growth opportunities and the cost of each source of finance. Where profits are volatile or uncertain, low gearing is wise because the firm cannot guarantee covering interest. Where profits are stable and there are profitable projects to fund, a higher level of gearing can be the better choice, exploiting cheap debt and boosting returns.

Judgement. A business should not always aim to keep gearing as low as possible. The most defensible position is that it should aim for the level of gearing that matches its profit stability and strategy — low gearing where profits are unpredictable or risk-tolerance is limited, but a higher, sensibly managed level of gearing where profits are stable and growth opportunities exist, because cheap debt can then magnify shareholder returns. So low gearing is the safer default, especially in uncertain conditions, but treating it as a permanent goal would, for many firms, sacrifice growth and returns. The aim should be an appropriate gearing for the firm's circumstances, not the lowest possible one.