What is a Gearing Ratio and How is it Calculated?

The term "gearing" refers to the proportion of a company's capital structure that is provided by debt as opposed to equity (or shareholders).

 

Liquidity is also a factor in the gearing ratio. However, it focuses on a company's long-term financial stability. When it comes to assessing a company's financial health, the gearing ratio is crucial. 

 

The gearing ratio assesses how the company in issue is using debt to obtain more value out of its capital, similar to how an automobile gear is utilized to get more power out of your car.

 

What is a Gearing Ratio?

 

A gearing ratio is a measure of a company's financial leverage, or the proportion of a company's capital that originates from outside sources (lenders) as opposed to internal sources (owners) (shareholders). Debt-to-equity, debt-to-capital, and debt-service ratios are all well-known gearing ratios.

 

Lenders and investors can use gearing ratios to judge whether or not to extend credit and whether or not to invest in a company. A higher gearing ratio signifies a higher level of financial risk. By dividing total debt by total equity, financial analysts can have a better understanding of a company's overall capital structure. 

 

The greater the ratio, the greater the risk of default. As a result, stifling growth is more of a roadblock to the company's progress. There are many alternative formulas that relate the owner's capital or equity to the long-term or short-term debt.

 

While there is no set gearing ratio that determines whether a firm is well-structured or not, general guidelines advise that it should be between 25% and 50% unless the company needs more debt to operate.

 

Gearing (sometimes known as "leverage") refers to the percentage of a company's assets that are financed with long-term debt.

 

Formula to Calculate Gearing Ratio

 

There are many other types of gearing ratios, but the debt-to-equity ratio is one of the most prevalent. You divide the long-term and short-term debt by the shareholder equity to arrive at this figure. If there are no other shareholders, you (the owner) are the sole shareholder, and all of the equity in this equation belongs to you.

 

(Long-term debt + Short-term debt + Bank overdrafts) ÷ Shareholders' equity = Gearing ratio

 

The times interest earned ratio, which is calculated as illustrated below, is another type of gearing ratio that is used to determine if a company can create enough profits to cover its recurring interest payments.

 

Interest payable + Earnings before interest and taxes = Gearing ratio

 

The long-term debt to equity ratio is another variant of the gearing ratio; it is less useful when a company has a lot of short-term debt (which is especially common when no lenders are willing to commit to a long-term lending arrangement). It is, nevertheless, useful when the majority of a company's debt is held in long-term bonds.

 

Analyze the Gearing Ratio

 

Fundamental analysis includes a lot of gearing ratio analysis. Because gearing ratios vary so much between businesses, it's frequently better to compare corporations to the industry average rather than companies from various industries or areas.

 

Please keep in mind that borrowing money to fund a company's operations isn't always a negative idea. The extra money from a loan can be used to grow a company's operations, enter new markets, and improve its product offerings, all of which can help the company's long-term success.

 

On the other hand, a company with a very low gearing ratio may be unable to expand while interest rates are low, so missing out on growth possibilities that their competitors may exploit. 

 

As a result, gearing ratios are only a part of the picture and do not provide a whole picture of a company's health. Make sure to include gearing ratios in your fundamental analysis, but not as a stand-alone metric, and to use them on a case-by-case basis.

 

 

Good and Bad Gearing Ratios

 

The particular company determines the best gearing ratio in comparison to other companies in the same industry. Here are some general principles for good and bad gearing ratios:

 

1. A gearing ratio of more than 50% is sometimes referred to as strongly levered or geared. As a result, the company would be at greater financial risk, as it would be more vulnerable to debt default and insolvency during periods of reduced profits and higher interest rates.

 

2. Investors and lenders often regard a gearing ratio of less than 25% to be low-risk.

 

3. For well-established businesses, a gearing ratio of 25 to 50 percent is often regarded as excellent or standard.

 

Financial Gearing and Businesses

 

Financial gearing can be used to enhance a company's capital structure in a variety of situations, including the following:

 

1. Shortage of Funds

 

A corporation that relies primarily on equity capital to fund operations throughout the year may face liquidity shortages that disrupt normal operations. In such a case, the best solution is to seek additional funds from lenders to fund the operations. As long as the company looks to be financially healthy, financial institutions and investors are willing to provide money.

 

2. Capital for Investment

 

A big amount of capital may be required by a corporation to finance major investments such as acquiring a competitor or purchasing the vital assets of a company that is quitting the market. 

 

Due to the time constraints, such investments may require immediate action, and shareholders may not be able to obtain the necessary funds. If the company is in excellent standing with its creditors, it may be able to acquire substantial sums of money rapidly if it meets the loan requirements.

 

3. Raising Capital without diluting Ownership

 

A firm has the option of choosing between debt and equity capital when seeking fresh cash to fund its operations. Because issuing more stocks will diminish their ownership position in the company, most owners prefer debt capital to equity capital. 

 

Without affecting the ownership structure, a profitable company can use borrowed funds to generate more revenues and use the returns to service the debt.

 

Strategies used by Corporations to Lower their Capital Gearing Ratio

 

Gearing ratios are generally used by financial institutions and creditors to assess a company's repayment capacity. As a result, they can construct the proposed loan's terms and conditions. Internal management also analyzes these ratios to forecast profit and cash flow in the future. 

 

Gearing ratios are typically greater when large investments are involved since they must cover such costs. Gearing ratios are largely used by financial institutions and creditors to determine the firm's repayment capacity and, as a result, to construct the terms and circumstances of a proposed loan.

 

Internal management also uses these measures to forecast future profit and cash flows. When a large amount of money is invested, gearing ratios tend to be greater since the company must fund the Capex with externally secured funds.

 

If your company's gearing ratio is high, you may need to give up more control in order to acquire money. A lender will insist that measures be put in place to guarantee funds flow in their way first, because the higher the gearing ratio, the bigger the risk of not being repaid. 

 

Covenants, for example, might be used to limit your future activities. A covenant may restrict you from paying dividends if money is still owing to you.

 

In most cases, a company can reduce capital gearing in one of four ways. Firms should reduce their capital gearing for a variety of reasons.

 

So, what are the things that businesses may do to lower their capital gearing?

 

1. Attempt to minimize Working Capital

 

To lower working capital, businesses must cut inventory levels, obtain payments from debtors swiftly, and extend payment terms to creditors. More money in less time will help you pay off your debt faster. (Take a look at the working capital ratio as well)

 

2. To Make Money, you can Sell your Shares

 

Firms will be able to pay off debts if they can sell shares. However, if a company wants to be in business for a long time, this is not a good strategy.

 

3. Increase Period Profits

 

Earning more profits is the best and most prudent strategy to lower capital gearing. It would be easier to pay off the debt and reduce the high gearing ratio if the company could create more cash flow (greater profits don't always indicate more cash inflow, but more cash inflow may normally mean better profits).

 

4. Converting Loans to Stock

 

Firms can convert loans into stock by issuing stock rather than cash. It will be beneficial in two ways. To begin with, businesses would not need to create additional income to pay off debt. Second, even if the companies have more cash, they will be able to put it to better use elsewhere, resulting in the debt being converted into stock.

 

Also Read | Monthly Recurring Revenue (MRR)

 

Limitations of Capital Gearing Ratio

 

The Capital Gearing Measure is a useful ratio for determining whether a company's capital is being used effectively. The capital gearing ratio is important to investors since it determines whether or not an investment is risky. 

 

If a company's capital consists mostly of interest-bearing funds, it is a riskier investment for investors. The investors' interests, on the other hand, would be protected if the company had greater common equity.

 

The sole possible drawback of the capital gearing ratio is that it isn't the only ratio to consider when considering an investment in a firm. This is the core reasoning at work. Let's imagine you're looking at Company A's capital structure. In 2016, Company A had 40 percent common shares and 60 percent borrowed funds. Because Company A is heavily geared, you now believe it is a risky investment. 

 

However, you must look beyond one or two years of data to gain a whole picture. You should look at the company's capital structure over the last decade to see if Company A has been able to keep high gear for a longer period of time. If you answered yes, this is a risky investment. 

 

However, if this is not the case and they have taken out a loan to meet their urgent needs, you may want to consider investing (subject to the fact that you check other ratios of the company as well).

 

Because most lenders and analysts use these financial ratios to determine an entity's degree of leverage, it is critical to comprehend the idea of gearing ratios. A higher equity ratio and a lower debt-to-equity ratio and debt ratio typically imply good financial health. 

 

Please keep in mind that gearing ratios should only be compared between companies in the same industry, as these ratios are highly industry-specific.