Accounting for Business Decisions

Accounting for Business Decisions, Semester 1, 2015: Assessment Task One

9 May 2015

Q1 . What does it mean to state that a firm is highly leveraged or geared?

Financial leverage (referred to as gearing) refers to the use of debt to finance the assets of the firm (Marshall et al 2012).The gearing ratio is the proportion of a company’s debt to its equity. The ratio indicates the financial risk to which a business is subjected.

A high gearing ratio is indicative of a great deal of leverage, where a company is using debt to pay for its continuing operations. A company with significantly more debt than equity is thought to be highly leveraged (Investopedia 2014). Two financial leverage measures, debt/equity and the debt ratio are used to indicate the extent to which a firm uses financial leverage. The most comprehensive form of gearing ratio is one where all forms of debt - long term, short term, and even overdrafts - are divided by shareholders' equity. Gearing focuses on the capital structure of the business – that means the proportion of finance that is provided by debt relative to the finance provided by equity (or shareholders).

The gearing ratio is also concerned with liquidity. However, it focuses on the long-term financial stability of a business. A firm with a gearing ratio of more than 50% is said to be highly geared. If a company has a high gearing ratio it means it has lots of long term borrowing. Any investment into a business (with a high gearing ratio) will need to closely look at the firm’s ability to cover long term loans especially if the economy is not doing well for example in a recession. People looking to invest in a highly geared business will also need to look at the level of dividends and the firm’s share prices to decide whether they will make any money from investing in the business.