Which statement about gearing is correct?

Which statement about gearing is correct?

• A. The business is lowly geared, indicating relatively low debt levels.
• B. Gearing has no relation to debt.
• C. If gearing is high, the business is highly geared and faces greater risk of insolvency.
• D. Gearing is primarily a liquidity measure.

Answer: (C)

Gearing is about financial leverage—the proportion of debt financing relative to equity (or assets). When gearing is high, a large portion of the company’s funding comes from debt, so there are substantial fixed obligations like interest and principal repayments to meet. This amplifies financial risk, because if profits fall or cash flow tightens, those obligatory payments can become hard to cover, increasing the chance of insolvency. That’s why the statement about high gearing signaling greater insolvency risk is the best. Gearing does relate to debt, and it’s not primarily a liquidity measure (liquidity looks at short-term ability to meet obligations, while gearing looks at long-term capital structure). A low gearing description is true but doesn’t capture the risk implications of high gearing, which is the key point.

Gearing is about financial leverage—the proportion of debt financing relative to equity (or assets). When gearing is high, a large portion of the company’s funding comes from debt, so there are substantial fixed obligations like interest and principal repayments to meet. This amplifies financial risk, because if profits fall or cash flow tightens, those obligatory payments can become hard to cover, increasing the chance of insolvency.

That’s why the statement about high gearing signaling greater insolvency risk is the best. Gearing does relate to debt, and it’s not primarily a liquidity measure (liquidity looks at short-term ability to meet obligations, while gearing looks at long-term capital structure). A low gearing description is true but doesn’t capture the risk implications of high gearing, which is the key point.