Capital gearing and its implications

The gearing ratio

Pearson's formula:

Gearing = fixed-cost capital / total capital employed x 100

• Fixed-cost capital: debentures, long-term loans and preference shares (they carry a fixed interest or dividend).
• Total capital employed: fixed-cost capital + ordinary share capital + reserves.

Broadly, over 50% is highly geared, below about 25% is low geared.

Why gearing matters

High gearing:

• interest must be paid whatever the profit, so the risk of not meeting payments is higher
• lenders may refuse further loans or charge higher rates
• profits for ordinary shareholders swing more widely: in good years their returns rise faster, in bad years they fall faster

Low gearing:

• safer, and borrowing capacity remains
• but shareholders may be missing the benefit of cheaper debt finance (interest is tax-deductible).

Gearing amplifies returns

Two companies each have capital of £10m and profit before interest of either £1m or £2m. Company H has £6m of 10% debentures; company L has none.

Effect of gearing (tax ignored)

Changing gearing

• Gearing rises when the company borrows more, issues preference shares or buys back ordinary shares.
• Gearing falls with a share issue (including a rights issue), retained profits growing reserves, or repaying debt.
• A bonus issue does not change gearing: it only moves amounts within equity.

Worked example

Debentures £6,000,000, preference shares £2,000,000, ordinary share capital £5,000,000, reserves £7,000,000. Calculate the gearing ratio and comment.

1. Fixed-cost capital = 6,000,000 + 2,000,000 = £8,000,000
2. Total capital employed = 8,000,000 + 5,000,000 + 7,000,000 = £20,000,000
3. Gearing = 8,000,000 / 20,000,000 x 100 = 40.0%

Answer: 40.0%: moderately geared, below the 50% level often taken as high

Check yourself

1. Long-term loans £3,600,000; ordinary share capital £4,000,000; reserves £2,400,000; no preference shares. Calculate gearing as a percentage to 2 decimal places.
   Show answer

   36.00 %. 3,600,000 / 10,000,000 x 100 = 36.00%.

2. Debentures £5,000,000, 6% preference shares £1,000,000, ordinary shares £2,500,000, reserves £1,500,000. Calculate gearing to 2 decimal places.
   Show answer

   60.00 %. Fixed-cost capital = 6,000,000; total = 10,000,000; gearing = 60.00%.

3. A company with debt of £4,000,000 and equity of £6,000,000 raises £2,000,000 through a rights issue. Calculate its new gearing to 2 decimal places.
   Show answer

   33.33 %. 4,000,000 / (4,000,000 + 8,000,000) x 100 = 33.33%.

4. Which is a risk of high gearing?
   • Shareholders lose their votes
   • Dividends must be paid each year
   • Share capital cannot be increased
   • Interest must be paid even when profits fall
   Show answer

   Interest must be paid even when profits fall. Fixed interest is a commitment regardless of profit.

5. What happens to gearing after a bonus issue?
   • It rises
   • No change
   • It falls
   • It becomes zero
   Show answer

   No change. A bonus issue moves reserves into share capital; total equity and debt are unchanged.

6. Profit before interest rises by 20% in a highly geared company. What happens to profit available for ordinary shareholders?
   • It rises by exactly 20%
   • It rises by less than 20%
   • It does not change
   • It rises by more than 20%
   Show answer

   It rises by more than 20%. Interest is fixed, so all of the extra profit goes to shareholders, which is a bigger percentage of a smaller base.

7. Explain why a bank may be reluctant to lend to a highly geared company.
   Show answer

   The company already has large interest payments, so there is a higher risk that it cannot pay the interest or repay the loan if profits fall.. High existing debt means greater risk of default on further lending.

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Sources

• Pearson Edexcel International Advanced Subsidiary/Advanced Level in Accounting specification (XAC11/YAC11), Issue 2

Last updated 8 November 2026. Spotted a mistake? Tell us.