The gearing ratio measures the percentage of capital employed that is financed by debt and long term finance. The higher the gearing, the higher the dependence on borrowings and long term financing. The lower the gearing ratio, the higher the dependence on equity financing. Traditionally, the higher the level of gearing, the higher the level of financial risk due to the increased volatility of profits.
Financial managers face a difficult dilemma.
Most businesses require long term debt in order to finance growth, as equity financing is rarely sufficient. On the other hand, the introduction of debt and gearing increases financial risk. But the company dependant on equity financing alone is unable to sustain growth.