I am currently studying Level 3 manual with Kaplan and I have reached the chapter on Solvency Ratios. I understand the calculation for a Gearing Ratio what I don't understand is how to explain the answer.
The workbook from Kaplan says that Gearing is a matter of degree but what effect does Gearing have on a business and what is a 'good' gearing ratio and what is a 'bad' gearing ratio?
Could someone please explain 'Gearing' to me in as basic English as possible?
Gearing put simply is a measure of how much of the business is financed by longer-term debt. The higher the percentage of longer-term debt financing, the less secure is the equity capital of the shareholders.
Let's say you have a company where equity capital is £1,500,000 and yet the company has borrowed £750,000 to finance operations. We would simply divide 750,000 by 1.500,000 to give us a percentage of 50%. If the borrowing was even higher, the company would be in a very insecure position. If there was an event that created a downturn for the company, these finance creditors could call in their finance and the company would then be in big trouble. Hence, the higher the gearing (finance debt to equity), the more instability the company is exposed to.
That's how I would define it, keeping it simple.
GrahamG
-- Edited by GrahamG on Saturday 13th of November 2010 12:57:00 PM
Isn't Gearing also a reflection of prior charge capital i.e. those providers of capital who have a claim on the reserves of a company before Ordinairy Shareholders?
-- Edited by ADAS on Friday 12th of November 2010 09:58:51 PM
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Tony
Responses are intended as outline only. Formal advice should be sort from your Institutes Technical Department or a suitably qualified Accountant.
