I n t e r a c t I v e t e X t foundations in Accountancy/ acca financial accounting (ffa/FA) bpp learning Media is an acca approved Content Provider

 

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4.3 Gearing/leverage 

Gearing or leverage is concerned with a company's long-term capital structure. We can think of a 

company as consisting of non-current assets and net current assets (ie working capital, which is current 

assets minus current liabilities). These assets must be financed by long-term capital of the company, 

which is either: 

(a) Shareholders' 

equity 

 

(b) Long-term 

debt 

The gearing ratio can be calculated as follows. 

FORMULA TO LEARN 

Gearing = 

Total long-term debt

Shareholders' equity + total long-term debt

 × 100% 

 

As with the debt ratio, there is no absolute limit to what a gearing ratio ought to be. A company with a 

gearing ratio of more than 50% is said to be highly geared, whereas low gearing means a gearing ratio of 

less than 50%. Many companies are highly geared, but if a highly geared company raises its level of 

gearing even more, it is likely to have problems borrowing in the future. However, it could lower its 

gearing by boosting its shareholders' capital, either with retained profits or by a new share issue. 

Leverage is the term used to describe the converse of gearing, ie the proportion of total assets financed 

by equity, and which may be called the equity to assets ratio. It is calculated as follows. 

FORMULA TO LEARN 

Leverage =  

Shareholders' equity

Shareholders' equity plus total long - term debt

× 100%  

or  

s

liabilitie

current

less

assets

Total

equity

rs'

Shareholde

 × 100% 

 

 

In the example of Furlong, we find that the company, although having a high debt ratio because of its 

current liabilities, has a low gearing ratio. Leverage is therefore high. 

  

20X8 20X7 

Gearing ratio  

= 

$100,000

$988,899

 

$100,000

$751,969

 

 

 

=  10% 

=  13% 

Leverage  

= 

$888,899

$988,899

 

$651,969

$751,969

 

 

 

=  90% 

=  87% 

As you can see, leverage is the mirror image of gearing. 

4.4 Interest cover  

The interest cover ratio shows whether a company is earning enough PBIT to pay its interest costs 

comfortably, or whether its interest costs are high in relation to the size of its profits, so that a fall in 

PBIT would then have a significant effect on profits available for ordinary shareholders. 

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