What defines as "better" gearing? (1 Viewer)

[qldbulls]

This is really grinding my "gears".
Is higher than the industry average better because you're encouraging growth? Or is lower better because its lessening risk?
In the context of this questions and its answer (D), it must be the former, but does that apply to all circumstances? Surely ridiculously high gearing can't be considered better? At first I thought there might be a set margin rule around the industry average for this but I can't find anything.

 

[jimmysmith560]

Essentially, a high debt-to-equity ratio means that a business is at higher risk because it has an excess of liabilities and/or it has a lower amount of equity. For a business to be in a more stable financial position, its debt-to-equity ratio has to be minimised, which can be done by reducing liabilities and/or increasing equity.

Determining the total equity component using the accounting equation A = L + OE leads to the following:

11000 = 8000 + OE
OE = 11000 - 8000
OE = 3000

Applying the debt-to-equity ratio:



This ratio is evidently worse than industry average and has worsened since 2017 (150% indicating better gearing than 266%), which is consistent with (D).

In terms of your question, a higher debt-to-equity ratio does not encourage growth, since the business would be considered to be in an unfavourable financial position and would thus not have the financial basis for growth. On the other hand, a lower debt-to-equity ratio implies lower financial risk for the business, making your second suggestion the correct one.

None of the figures in the question regarding gearing are particularly great. Uncle Dave's Warehouse's figure of 150% in 2017 indicates an unfavourable financial position and the industry average figure of 100% in 2018, while technically placing a business in a safe financial position, would preferably be lowered to a more acceptable ratio.

I hope this helps!

 

[qldbulls]

Essentially, a high debt-to-equity ratio means that a business is at higher risk because it has an excess of liabilities and/or it has a lower amount of equity. For a business to be in a more stable financial position, its debt-to-equity ratio has to be minimised, which can be done by reducing liabilities and/or increasing equity.

Determining the total equity component using the accounting equation A = L + OE leads to the following:

11000 = 8000 + OE
OE = 11000 - 8000
OE = 3000

Applying the debt-to-equity ratio:



This ratio is evidently worse than industry average and has worsened since 2017 (150% indicating better gearing than 266%), which is consistent with (D).

In terms of your question, a higher debt-to-equity ratio does not encourage growth, since the business would be considered to be in an unfavourable financial position and would thus not have the financial basis for growth. On the other hand, a lower debt-to-equity ratio implies lower financial risk for the business, making your second suggestion the correct one.

None of the figures in the question regarding gearing are particularly great. Uncle Dave's Warehouse's figure of 150% in 2017 indicates an unfavourable financial position and the industry average figure of 100% in 2018, while technically placing a business in a safe financial position, would preferably be lowered to a more acceptable ratio.

I hope this helps!

Ahh that makes alot more sense now, I must've got my numbers confused because I ended up with a gearing lower than 100% lol. So just to make sure the best gearing is circumstantial right, if say the business was in fact geared at something like 20% this would be bad as it would be too cautious?
Thank you for such an in depth response btw

 

[jimmysmith560]

Ahh that makes alot more sense now, I must've got my numbers confused because I ended up with a gearing lower than 100% lol. So just to make sure the best gearing is circumstantial right, if say the business was in fact geared at something like 20% this would be bad as it would be too cautious?
Thank you for such an in depth response btw

No worries. You could argue that, from a practical perspective, a debt-to-equity ratio that is too low may negatively affect the business in the sense that, despite the fact that a ratio in this region implies that the business is in a good financial position, the fact that its reliance on debt finance is low could potentially limit its profits. This comes from the premise that the more highly geared the business, the greater the risk for the business but the greater potential for profit.

 

[qldbulls]

Gearing is basically a measure that shows the percentage of assets that are funded by external sources, a higher gearing ratio is bad because it means the firm becomes less solvent and it also increases risk to creditors/shareholders (as the business accumulates more debt). Also not sure what you mean by being too cautious?

Yeah like Jimmy said, by being to cautious I mean if a business has too low a gearing ratio it’s becomes a detriment as the business is not making full use of its “capital loaning capacity”. I thought the “advantages and disadvantages of debt/equity finance” part of the syllabus would apply here as an imbalance of capital sources in the form of very low gearing would exacerbate the disadvantages of equity finance? i.e. equity is more expensive, results in a more diluted ownership, etc.
Since that section also covers the risk side of gearing, that’s why I was thinking it could apply the other way