Gearing – What debt to use

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    jrow
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    hi,

    I was under the impression that the debt to use in gearing is long-term debt, but in one answer I’ve seen, they have included overdraft as LT debt – I thought this short term debt?

    would you mind clarifying please? much appreciated


    Profile photo of Kevin Kelly
    Anonymous
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    Hi Irow,

    There is no universal definition of GEARING.

    In F9, I find it makes a lot of sense to define Gearing as D:E (i.e the ratio of debt to equity). Some commentators measure gearing as the ratio of Debt to Equity + DEBT (or, debt to total capital employed).

    Like I have said, my preference is to always advise (for many reasons) using the D:E approach were possible.

    In the case of the numerator (Debt) there is again no hard and fast rule when it comes to selecting the components to include here. You need to look carefully at the components of the Capital Structure of the Balance sheet in the question when deciding on the components to use in your definition of Debt. But I would suggest following this rule-of-thumb:DEBT = Long Term Debt + Bank Overdraft – Cash Balance + Preference Capital.

    Often B/O finance can be significant in terms of risk and size and so in my opinion it is safer to always include it in your calculation of capital gearing.
    In the case of the denominator (EQUITY), include here the Issued Share Capital + ALL the Reserves

    Finally, the Gearing Ratio can be measured using BOOK or Market Values. It makes more sense to measure gearing using market values, but in reality it is normally measured in BOOK terms! However, as far as the F9 exam is concerned your focus needs to be primarily on the use of Market Values to measure the Capital Gearing Ratio.

    Hope this helps, Kevin Kelly

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