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Limited company accounts

Section 7 of 7

Gearing Ratio

Definition and formula

Gearing measures the proportion of a company's long-term funding that comes from debt (non-current liabilities) relative to total long-term funding.

Gearing = Non-current liabilities / (Non-current liabilities + Equity) × 100

Interpretation

GearingMeaning
Above 50%Higher risk — debt exceeds equity in long-term funding; fixed interest must be paid regardless of profit
Below 50%Lower risk — equity dominates; dividends are variable and only paid if profitable

Funding method comparison

Funding methodCostRisk
Debentures (non-current liabilities)Fixed % interest per annum regardless of profitHigh
Ordinary share capitalVariable dividends — only paid if profitableLow
ReservesNone — internally generatedNone

Ordinary shares vs debentures

FactorOrdinary sharesDebentures
Where on SFPEquity sectionNon-current liabilities
Cost of financeVariable dividendsFixed % interest (finance costs in IS)
Effect on gearingReduces gearingIncreases gearing
Effect on ownershipMay dilute if issued externallyNo effect
Security requiredNoneOn company assets
TimescalePermanentLong-term but repayable

Worked example

Co A £000Co B £000
Total equity7 5406 204
Debenture loans4 0606 996
Gearing4 060 / 11 600 × 100 = 35%6 996 / 13 200 × 100 = 53%
  • Co A: below 50% — debt is about ⅓ of long-term funding — lower risk
  • Co B: above 50% — debt exceeds equity in long-term funding — higher risk; fixed interest must be paid even if the company makes a loss

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