A level Business Revision - Gearing Ratio Transcript, AI Summary & Key Points

00:03 [Music] hi there in this video we're going to take a look at the gearing ratio in particular we're going to try and have a look at the consequences for organizations of being highly and lowly geared and some different strategies the business might use if it decides it wants to try and reduce its gearing ratio so we've got the gearing formula behind us on the board here let's explain to you what that actually means when we're calculating a business's gearing what we're doing is having a look at all of the capital that a

00:35 business has employed into its organization so we're going to have a look at the total sum of money that a business has raised from its shareholders from its retained profits and crucially from borrowing as well but what we're going to do with the gearing ratio is we're going to calculate what percentage of all of that total Capital employed in the organization has come from borrowing so the gearing ratio really look looks at how Reliant a business is on borrowing funds in order to invest Capital into the organization

01:10 and consequently when we work that answer out we'll get a percentage for the organization the percentage of its capital employed that it's had to borrow and we can split that into three different categories we can talk about whether the business's gearing ratio is in the lowly geared bracket moderately geared bracket or the highly geared bracket so if an organization is lowly geared it means that when we've calculated its gearing ratio it has borrowed less than a quarter of the total Capital that's being employed in

01:40 the organization so it's somewhere in the N to 24% bracket many businesses strive to be what we know as moderately geared organizations so that's where anywhere between a quarter and a half of all the capital that they've employed in their organization they have borrowed in the forms of loans mortgages and other long-term sources of Finance like debentures and things like that interestingly the some organizations have actually decided to be what we call as highly geared where more than half of all of the capital that

02:13 they've raised and employed in their organization has been funded through borrowing so where more than a half of all their capitals coming from loans or mortgages or sources of finance that are going to need to be repaid now being a highly geared organization brings with it certain consequences and most of those revolve around the fact that this business has taken out a significant percentage of its capital in the form of loans and mortgages and debentures and this is funding that is going to be needing to be repaid

02:46 crucially it's going to need to be repaid with interest as well so organizations that are highly geared become quite vulnerable to any changes in interest rates so if a firm has a significant ific percentage of its capital that's raised through loans and borrowings if there is an increase in interest rates if Bank interest rates rise even if that's a relatively small increase it could mean that the business is paying back significantly more interest per month than it was when interest rates are lower and that can have

03:20 consequences for the liquidity of the organization so if a firm is struggling with liquidity and there's a rise in interest rate this could be the factor that really means that this business starts to struggle for cash and we know that there are consequences for organizations if they are cash poor however if a firm is highly geared that might be absolutely acceptable if this is a firm that's able to service those debts quite readly if it's a business that is not experiencing liquidity problems and is Comfortably paying

03:51 off all of these loans that they have taken out then maybe they might see being highly geared as something that is per L plausible for that organization if an organization is lowly geared then it doesn't have such a Reliance on borrowing so if interest rates do rise that is something that the business might be able to absorb a lot more easily because a much smaller percentage of their Capital employed in the organization has been borrowed but being lowly geared doesn't come without consequences and the thing we want to

04:22 think about is that if a business is Raising capital and a very small percentage of it is coming from borrowing where is the rest coming from is it coming from uh from shareholders and is it even coming in the form of retained profits so if we're retaining a lot of our profits in the organization because we want to fund capital expenditure projects and we don't want to borrow money we want to fund it organically ourselves we've got to acknowledge that that's retained profits that we are then keeping back from

04:52 shareholders it's profit that we're not Distributing to the owners of the organization and that may be met with different responses by different shareholders longer term investors may be perfectly comfortable with the fact that we're a lowly geared organization that we're retaining profit in the organization we're investing in the future and this might improve longer term returns for shareholders but shorter term investors might look at these high amounts of retained profits that we're keeping in the organization as

05:22 funds that we are taking back from shareholders funds that we are holding back from the uh the people that run own and invested in the organization and they may see that as something that is detrimental to their interest so shortterm shareholders can actually be a little bit anxious about firms being lowly geared because although they might be in a stronger position and they might be less vulnerable to changes in interest rates they're looking at that lack of borrowing and seeing it as perhaps something that they're

05:51 having to fund rather than the business taking out loans mortgages to fund their capital expenditure instead so this is why many firms decide to try and set themselves targets towards pitching themselves in the moderately geared range so they're striking a balance there they're borrowing enough money so that they can invest in new projects invest in new schemes and not have to rely too heavily on the equity that they might get from shareholders or through retaining profits but they're not borrowing so much money that

06:23 they're jeopardizing the the viability of the organization and liquidity of the organization particularly if interest rates were to rise so we've got three different classifications of gearing if a firm is highly geared it might set itself the target of trying to reduce its gearing ratio if it is worried about the risk attached to being a highly geared organization most basic way of doing that is paying back some of its long-term borrowing but of course that's going to suck cash out of the organization to do that an

06:52 alternative strategy might be to increase the amount of retained profit that they keep so they can fund more of their Capital employed organically through their retained profits but we' talked about how that might be met by different responses from different shareholders an alternative way to reduce your gearing ratio is of course to issue more shares in the organization and invite new owners into the organization but again that comes with its own issue surrounding the control and the governance of the business

07:22 hopefully gearing is a topic that we can Embrace if it comes up on the exam good Lu with your revision keep on taking the beers