How does a high gearing ratio impact a business?

A high gearing ratio can increase a business's financial risk but also potentially enhance returns on equity.

A gearing ratio is a measure of a company's financial leverage, indicating the extent to which its operations are funded by debt compared to equity. When a business has a high gearing ratio, it means a significant portion of its capital comes from debt. This can have both positive and negative implications.

On the positive side, using debt can magnify the returns on equity if the business is successful. This is because the cost of debt (interest) is usually lower than the cost of equity. Therefore, if a business can earn a higher return on the borrowed money than the interest it pays, the excess return will benefit the shareholders. This is known as financial leverage or the gearing effect.

However, a high gearing ratio also increases the financial risk of a business. This is because the company must meet its debt obligations, i.e., interest payments and principal repayments, regardless of its financial performance. If the business does not generate enough cash flow to meet these obligations, it could face financial distress or even bankruptcy.

Moreover, a high gearing ratio can make a business more vulnerable to economic downturns. In a recession, revenues may fall, making it harder to service debt. Also, if interest rates rise, the cost of debt will increase, putting further pressure on the business's finances.

Finally, a high gearing ratio may affect a company's credit rating. Credit rating agencies, such as Standard & Poor's and Moody's, consider a company's gearing ratio when assessing its creditworthiness. A high gearing ratio may lead to a lower credit rating, making it more expensive for the company to borrow in the future.

In conclusion, while a high gearing ratio can enhance returns on equity, it also increases a business's financial risk and vulnerability to economic downturns. Therefore, businesses need to carefully manage their gearing ratio to balance the potential benefits and risks.