Capital Gearing, Business Risk and Financial Risk

Borrowing is a bet. A company that borrows promises to pay interest whatever happens, and keeps for its shareholders everything earned above that promise. If the business does well, the shareholders gain more than if they had funded everything themselves; if it does badly, the interest still has to be paid, and the shareholders lose faster.

Gearing is the name for how much of the company is financed by such promises, and the risk it adds is called financial risk. It sits on top of the risk of the business itself, which comes from what the company sells, how it makes it and how much of its cost is fixed. This topic is the first of the group on capital structure.

It explains how to measure gearing (prior charge capital, the four formulae, book values and market values), financial and operating leverage and how they combine, business risk and financial risk, how gearing changes earnings per share (with a worked comparison of equity and debt financing and the indifference point), and the benefits and weaknesses of high gearing, with worked examples.

The next topic examines the theories of how gearing affects the cost of capital and the value of the company.

The measurement of gearing on book and on market values, and the benefits and weaknesses of gearing, were tested in November Diet, 2025, Question 7(a) and (b) (9 marks in all). Read project-specific cost of capital and the adjusted weighted average cost of capital first.

Measuring capital gearing

Capital structure is the mixture of equity and debt used to finance a company’s assets. Equity is the capital provided by ordinary shareholders. Prior charge capital (PCC) is capital that has to be serviced before equity receives anything: preference share capital plus long-term liabilities (loans, bonds, finance leases). A bank overdraft is included only if it is a relatively permanent source of capital. There are four ways to express gearing:

• equity ÷ PCC;
• PCC ÷ equity (the debt to equity ratio);
• equity ÷ (equity + PCC); and
• PCC ÷ (PCC + equity), the preferred form unless the question says otherwise.

Book values or market values. The book value of equity is ordinary share capital plus reserves. The market value of equity is the number of shares × the share price, and does not add reserves (their effect is already in the price). Market values are preferred wherever possible, because they show the capital the company would have to raise or repay at today’s prices.

Example: Delta has 500m ordinary shares of ₦1 priced at ₦4.80, reserves of ₦700m, 100m 12% preference shares of ₦1 priced at ₦0.80, ₦600m nominal of 10% bonds priced at ₦90 per ₦100, and a long-term bank loan of ₦300m.

The two measures differ a great deal: on book values Delta looks highly geared (45.5%), but the market values the equity at twice the book figure, so the true burden of debt is much lighter (27.7%). High gearing means a high proportion of PCC, which raises the financial risk of the equity; low gearing means the company may be failing to use the benefits of debt.

Operating and financial leverage

Leverage means using fixed costs or fixed-charge finance to magnify the effect of a change in sales or profit.

• Operating leverage = contribution ÷ EBIT = % change in EBIT ÷ % change in sales. It measures how much a change in sales is magnified at the operating profit by the fixed operating costs.
• Financial leverage = EBIT ÷ profit before tax = % change in earnings per share ÷ % change in EBIT. It shows how much interest magnifies a change in EBIT at the profit before tax.
• Combined leverage = operating leverage × financial leverage = % change in earnings per share ÷ % change in sales.

Example: sales ₦5,000m, variable costs ₦2,000m, fixed costs ₦1,500m, interest ₦300m. Contribution is ₦3,000m, EBIT ₦1,500m and profit before tax ₦1,200m. Operating leverage = 3,000 ÷ 1,500 = 2.0; financial leverage = 1,500 ÷ 1,200 = 1.25; combined = 2.5. If sales rise 10% to ₦5,500m, contribution rises to ₦3,300m and EBIT to ₦1,800m (+20%), and profit before tax to ₦1,500m (+25%): a 10% rise in sales gives a 25% rise in profit before tax. The leverage works in reverse when sales fall.

Another measure is interest cover = EBIT ÷ interest = 1,500 ÷ 300 = 5 times: how far profit could fall before interest is not covered.

Business risk and financial risk

Business risk is the risk of the company’s operations: that revenue, costs and profits will vary because of the industry, the economy, competition, management decisions and the proportion of fixed costs. It is sometimes called operating risk or revenue risk and is reflected in the degree of operating leverage and in the asset beta.

Financial risk is the additional risk borne by shareholders because the company uses debt: the variability of profit after interest, with credit risk, liquidity risk and interest rate risk. A company has both: a stable utility with a lot of debt has low business risk but high financial risk; a technology start-up with no debt has high business risk and no financial risk. Shareholders bear the two together.

How gearing changes earnings per share

A company needs ₦2,000m of new capital. Plan 1: all equity, 400m new shares at ₦5. Plan 2: ₦1,000m of 15% debt and 200m new shares at ₦5. Tax is 30%. Earnings per share (EPS) at different levels of EBIT:

The two plans give the same EPS at an EBIT of ₦300m, the indifference point (the point where E ÷ 400 = (E − 150) ÷ 200, so E = 300). Above it, debt raises EPS: at ₦500m, EPS is ₦1.23 against ₦0.88. Below it, debt lowers EPS, and at ₦150m the whole profit is absorbed by interest. The gain is possible because the return on the new capital (EBIT of ₦500m on ₦2,000m is 25% before tax) exceeds the 15% interest rate.

So gearing works as an amplifier for shareholders in good times, and in bad times it does the opposite. Higher gearing also makes EPS more volatile, which investors recognise by asking for a higher return on equity (the next topics).

Benefits and risks of gearing

• Benefits: debt is a cheaper source of capital than equity (lower risk to the lender, tax relief on interest); it can raise EPS and the return on equity if the return on investment exceeds the after-tax cost of debt; existing shareholders keep control (no new shares); and if the lender’s return is fixed, shareholders keep the extra profit.
• Weaknesses: interest must be paid whether or not there is profit, and failure to pay can lead to default and liquidation; EPS and dividends become more volatile; shareholders’ required return rises with the risk; lenders may impose covenants and ask for security; the costs of financial distress (lost customers and suppliers, forced sales) rise with debt; and the capacity to borrow in a crisis is reduced.
• Weaknesses of the measure itself: book and market values give very different figures; leases and other off-balance-sheet finance may not be counted; and the treatment of overdrafts and of convertibles is a matter of judgement.

The ideas in more depth

Why operating and financial leverage multiply

Fixed operating costs magnify a change in sales into a bigger change in EBIT. Fixed interest then magnifies the change in EBIT into a bigger change in profit for shareholders. The two effects are applied one after the other, so the combined effect is their product.

A company with high fixed costs and high debt is therefore extremely sensitive to sales: it is the most exposed to a downturn, and a sensible company with high operating leverage keeps its financial leverage low.

Why gearing is not simply good or bad

Debt is cheap in itself, but it raises the risk of the equity. Whether it creates value, or only moves risk from one pocket to another, is the central question of capital structure theory, taken up in the next topics. In practice a company chooses a level of gearing that its cash flows can bear with a margin of safety, and watches interest cover and the covenants.

Sources and references

• No accounting standard defines gearing; ratios vary between companies and lenders, so state the formula used. For the measurement of lease liabilities see International Financial Reporting Standard (IFRS) 16 Leases; the Nigeria Tax Act 2025 allows tax relief on interest within its limits.

These points are stated as at 5 November 2026.

Worked examples

1. Total.
   920 + 2,400 = ₦3,320m.
2. Gearing.
   920 ÷ 3,320 = 27.7%.

1. Operating.
   3,000 ÷ 1,500 = 2.0.
2. Financial.
   1,500 ÷ 1,200 = 1.25
   combined 2.0 × 1.25 = 2.5.

1. Cover.
   500 ÷ 150 = 3.3 times.

How to answer in the exam

• State the formula used and whether values are book or market.
• List the components of PCC and value each at the right figure.
• Explain the difference between book and market measures in terms of what each shows.
• Discuss benefits and weaknesses with reference to the case, including risk and tax.

Common mistakes in the exam

• Adding reserves to the market value of equity.
• Using the nominal value of bonds instead of the market value.
• Leaving preference shares out of PCC.
• Mixing book and market values in one ratio.
• Confusing operating and financial leverage.
• Saying that gearing always raises earnings per share.

Quick revision

• Gearing = PCC ÷ (PCC + equity); market values preferred; market equity = shares × price.
• Operating leverage = contribution ÷ EBIT; financial leverage = EBIT ÷ profit before tax.
• Business risk (operations) and financial risk (debt) add together.
• Gearing raises EPS above the indifference point and lowers it below.

Practice questions

These are original questions written in the style of the Institute’s exams. Try each one before you open the answer. Section A is a recall check, because the paper itself is written.

Recall check: multiple choice

Section B style: written questions

A further written question

Model answers

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