Gearing in a Nutshell
Gearing measures the proportion of a business’s capital that comes from long-term borrowing rather than shareholders’ equity. A gearing ratio above 50% means the company relies more on debt than equity, which increases financial risk but can also boost returns for shareholders during profitable periods.
Gearing Definition
Gearing is a financial ratio that compares a company’s long-term debt (non-current liabilities) to its total capital employed. Capital employed is the sum of shareholders’ equity and non-current liabilities. The formula is:
Gearing (%) = (Non-current liabilities / Capital employed) x 100
A company with a gearing ratio of 25% funds roughly a quarter of its long-term capital through borrowing. A company at 70% funds the majority through debt. The ratio tells you how dependent a business is on borrowed money.
Why does this matter? Borrowed money must be repaid, usually with interest. If a company earns strong profits, the interest payments are manageable and shareholders keep the rest. If profits fall, those fixed interest payments do not shrink with them. The business still owes the same amount. This is why gearing is fundamentally a measure of financial risk.
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Gearing Characteristics/Features
Gearing has several defining characteristics.
- It is expressed as a percentage: A ratio below 50% is considered low gearing, meaning the business relies more on equity. Above 50% is high gearing, meaning debt dominates.
- Interest is a fixed cost: Unlike dividends, which directors can choose to reduce or skip, interest payments are contractual obligations. Missing them can lead to legal action or insolvency. This fixed nature is what makes high gearing risky during downturns.
- It only considers long-term borrowing: Short-term liabilities like trade payables or overdrafts are left out. This is because long-term debt represents a structural funding decision, not a temporary cash flow issue. The ratio therefore reflects a deliberate strategic choice about how the business finances its operations and growth.
- It can change without extra borrowing: If a business makes losses and its equity shrinks, the gearing ratio rises automatically, even if debt stays the same.
Examples of Gearing
Consider Tesco. As a large supermarket chain with significant property assets, Tesco has historically carried substantial long-term debt to fund store acquisitions and distribution centres. Its gearing ratio has fluctuated but often sits above 40%. The predictable revenue from millions of daily shoppers gives Tesco confidence that it can meet interest payments consistently.
Contrast this with a technology start-up like Monzo in its early years. Start-ups typically have low or zero gearing because banks are reluctant to lend to unproven businesses. Instead, they raise equity from venture capital investors. The trade-off is that founders give away ownership, but they avoid the pressure of fixed interest payments while revenue is uncertain.
A third example: Rolls-Royce plc saw its gearing rise sharply during the pandemic when revenues collapsed but its debt obligations remained. The company had to negotiate new credit facilities and issue new shares to stabilise its finances, illustrating how quickly high gearing can become dangerous when trading conditions deteriorate.
Advantages & Disadvantages of Gearing
Advantages
Tax-Deductible Interest Payments
Interest on debt is an allowable expense that reduces a company’s taxable profit. If a business borrows £1 million at 5% interest, the £50,000 annual cost reduces its corporation tax bill. This makes debt cheaper in real terms than equity, where dividends are paid from post-tax profits. The business retains more cash overall, which can be reinvested into operations or used to strengthen its competitive position.
Retained Ownership and Control
When a business borrows rather than issuing new shares, the existing shareholders keep their ownership percentage intact. This means they do not dilute their voting power or their share of future profits. For a family-run business or a founder-led company, this is significant: they maintain strategic control while still accessing the capital needed to grow.
Magnified Returns for Shareholders
If a company earns a return on investment that exceeds the interest rate on its borrowing, the surplus flows entirely to shareholders. For example, if borrowed funds generate a 12% return but the interest rate is 5%, shareholders benefit from the 7% difference. This effect, known as financial leverage, means that during profitable periods, highly geared companies can deliver stronger returns on equity than low-geared competitors.
Disadvantages
Fixed Repayment Obligations Regardless of Performance
The most significant disadvantage of high gearing is that interest payments do not adjust when profits fall. A business earning £500,000 with £200,000 in annual interest costs keeps £300,000. If profits drop to £250,000, the business keeps just £50,000. If profits fall below £200,000, the company cannot cover its interest, potentially leading to cash flow crises, asset sales, or insolvency. This rigidity makes high gearing dangerous in volatile markets.
Reduced Borrowing Capacity
A company with an already high gearing ratio will find it harder to borrow more in the future. Lenders assess risk before approving loans, and a heavily indebted business represents a greater default risk. This means the company may be unable to access finance when it needs it most, such as during an unexpected opportunity or a market downturn requiring emergency investment. The business loses financial flexibility precisely when flexibility matters.
Increased Vulnerability to Interest Rate Rises
Most business loans carry variable interest rates or require refinancing at current rates when they mature. If the Bank of England base rate rises, a highly geared company faces significantly increased costs. A business with £5 million in debt would see its annual interest bill rise by £50,000 for every 1% rate increase. This squeezes profit margins and can force difficult decisions about cutting costs elsewhere, potentially including redundancies or reduced investment in product development.
Pressure on Dividend Payments
When a large proportion of profit goes toward interest payments, less remains for shareholder dividends. This can make the company’s shares less attractive to investors, potentially lowering the share price. A falling share price increases the cost of raising equity in the future and can trigger a negative cycle where the company becomes more dependent on debt, pushing gearing even higher.
Evaluating the Usefulness of Gearing
Whether a particular gearing level is beneficial or harmful depends entirely on context. The same ratio can be perfectly safe for one business and reckless for another.
Market Conditions and Revenue Stability
A business operating in a stable market with predictable demand can sustain higher gearing more safely. Utility companies like National Grid carry high debt because customers pay their energy bills regardless of economic conditions. A luxury goods retailer faces far more volatile demand, so the same gearing ratio would represent much greater risk. The key question is whether the business can reliably generate enough cash to cover its interest payments through different economic cycles.
Business Objectives
A company pursuing rapid growth may deliberately increase its gearing to fund expansion without diluting ownership. If the objective is market share, borrowing to open new locations or acquire competitors can be rational. However, if the objective is survival during a recession, reducing gearing becomes the priority. The appropriateness of any gearing level depends on what the business is trying to achieve and over what time horizon.
Competitive Position
If competitors are investing heavily, a low-geared company may feel pressure to borrow and match their spending. Refusing to invest could mean losing market share. Equally, if a competitor is highly geared and interest rates rise, a low-geared rival gains an advantage because its cost base is more flexible. Gearing decisions are therefore not made in isolation: they are influenced by what others in the industry are doing.
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Practice Exam-Style Multiple Choice Questions for Gearing
Q1 A company has non-current liabilities of £400,000 and capital employed of £1,000,000. What is its gearing ratio?
Show the answer
Correct answer: B. Gearing = (£400,000 / £1,000,000) x 100 = 40%.
Q2 Which of the following would cause a company’s gearing ratio to increase?
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Correct answer: C. A large loss shrinks equity, so non-current liabilities become a larger proportion of capital employed.
Q3 A highly geared company is most at risk when:
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Correct answer: B. Rising rates increase interest costs while falling demand reduces the revenue needed to cover them.
Q4 One advantage of high gearing is that:
Show the answer
Correct answer: B. Interest reduces taxable profit, which makes debt cheaper than equity finance. The other options are not true of borrowing.
Practice A-Level Exam-Style Questions for Gearing with a Case Study
Read the following case study, then answer the questions below.
FreshBrew Coffee Ltd operates 15 coffee shops across the Midlands. It has non-current liabilities of £1.2 million and shareholders’ equity of £800,000. The company is considering borrowing an additional £500,000 to open five new shops. Interest rates have recently risen from 4% to 6%. Annual operating profit is £320,000.
- Calculate FreshBrew’s current gearing ratio.3 marks
- Explain one reason why FreshBrew’s gearing ratio might concern its bank manager.4 marks
- Analyse the impact of the proposed additional borrowing on FreshBrew’s financial position.9 marks
- To what extent does a high gearing ratio always represent a problem for a business?16 marks
- Evaluate whether a business should prioritise reducing its gearing ratio during a period of economic uncertainty.20 marks
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