Define gearing and explain its significance for financial risk and sustainability.

Define gearing and explain its significance for financial risk and sustainability.

• A. Gearing is the ratio of assets to equity; higher gearing indicates lower risk.
• B. Gearing is the ratio of debt to equity; higher gearing indicates greater leverage and risk, affecting interest coverage and solvency.
• C. Gearing is the ratio of revenue to expenses; higher gearing improves solvency.
• D. Gearing is the ratio of cash to net income; higher gearing reduces risk.

Answer: (B)

Gearing measures financial leverage by comparing how much of a company’s capital is funded with debt against equity. It shows how reliant the business is on borrowed funds. The higher the gearing, the more leverage the company has, and the greater the fixed obligations from debt (like interest and repayments) relative to profits. That elevates financial risk because if profits fall or cash flows tighten, there’s a tougher time meeting interest payments and repaying debt, which can threaten solvency and the firm’s long-term resilience. In turn, this affects sustainability since a highly geared firm faces higher borrowing costs, potential difficulty in raising funds, and greater vulnerability to economic shocks. The correct description identifies gearing as the debt-to-equity ratio, and acknowledges that higher gearing signals more leverage and higher risk, impacting interest coverage and solvency. The other options mix up what gearing compares (assets, revenue and expenses, or cash and net income) and do not reflect how gearing captures debt-driven leverage and risk.

Gearing measures financial leverage by comparing how much of a company’s capital is funded with debt against equity. It shows how reliant the business is on borrowed funds. The higher the gearing, the more leverage the company has, and the greater the fixed obligations from debt (like interest and repayments) relative to profits. That elevates financial risk because if profits fall or cash flows tighten, there’s a tougher time meeting interest payments and repaying debt, which can threaten solvency and the firm’s long-term resilience. In turn, this affects sustainability since a highly geared firm faces higher borrowing costs, potential difficulty in raising funds, and greater vulnerability to economic shocks.

The correct description identifies gearing as the debt-to-equity ratio, and acknowledges that higher gearing signals more leverage and higher risk, impacting interest coverage and solvency. The other options mix up what gearing compares (assets, revenue and expenses, or cash and net income) and do not reflect how gearing captures debt-driven leverage and risk.