Gearing

What is Gearing?

Gearing is a financial concept used to evaluate how a company finances its operations. It assesses the balance between the money a company borrows (debt) and the money invested by its owners (shareholders' equity). In simple terms, it helps us understand whether a company is relying more on debt or equity to run its business.

In theory, investors prefer a low-geared business since it indicates low risk and high financial stability.

To calculate gearing, you use a formula, which is shown as a percentage. This formula looks at the company's debt compared to its equity:

Gearing (%) = (Long-term-debt + short- term debt + bank overdraft) / (shareholder’s equity) * (100)

This percentage tells us how much of the company's financial resources come from debt.

Whether a gearing ratio is good or bad depends on the specific company and the industry it operates in. But we can generally say:

• A high gearing ratio (above 50%) is often seen as risky because it indicates a high degree of leverage and means the company relies heavily on debt to operate. In tough economic times, such companies can struggle to meet their financial obligations and may face bankruptcy.
• A low gearing ratio (below 25%) is generally considered safe. It indicates that the company doesn't heavily rely on debt to operate and is more financially secure.
• An ideal gearing ratio falls between 25% and 50%. It shows a good balance between debt and equity financing, which can be a sign of efficient financial management.

gearing ratios

Let's take a look at some of the gearing ratios below:

1. Debt-to-Asset Ratio

A debt-to-asset ratio greater than one implies that a business has more debt than assets. Conversely, a ratio of less than one means that the firm has more assets than debt.

We can say that any organization with a high debt-to-asset ratio is highly leveraged and may lack financial stability.

Formula is:

Debt-to-Asset ratio (%) = Total Liabilities/ Total assets * 100 

A less than 0.5 implies that most of the company's assets are financed through equity. In contrast, one greater than 0.5 means most of the company's assets are funded through debt. The maximum normal value is 0.6-0.7

2. Non-Current Debt-to-Asset Ratio

The above ratio indicates what percentage of the total assets is financed through long-term debt. A higher ratio means the company is more leveraged, owning a lower number of its assets. 

In this scenario, the business would be required to sell more assets to eliminate its debt if it goes bankrupt. It would also be required to generate more substantial revenue and cash flow for a more extended period to repay its debt.

Formula is:

Non-Current Debt-to-Asset Ratio (%) = Non-Current Debt/ Total Assets * 100

3. Equity-to-Asset Ratio (%)

The above ratio indicates the proportion of a company's total assets financed by shareholder's equity. A high equity ratio is usually a good sign here as it implies that the company is in an excellent position to pay its debtors. On the other hand, a low ratio means the business is prone to bankruptcy.

The equity ratio also sheds light on a company's financial strength. For a better understanding, we can say that a higher contribution of shareholders to capital indicates a better long-term solvency position.

Formula is:

Equity-to-Asset Ratio (%) = Total equity/ Total assets * 100

But what is the importance of having a decent equity ratio?

A good equity ratio is paramount for any organization, as it means they have to pay less interest and have more cash on hand for future growth opportunities. 

Likewise, a company with a lower equity ratio is more prone to losses since a large proportion of its earnings is spent on paying interest. Higher interest payable on loans takes a toll on the profit of any company.

Additionally, a higher equity ratio provides easier access to capital at favorable interest rates. In contrast, a lower equity ratio makes it inconvenient for a company to obtain loans from banks and other financial institutions. The reason is that lenders will give it at higher interest rates even when they receive a loan.

4. Debt-to-Equity Ratio (%)

This financial ratio indicates the relative proportion of an entity's equity and debt used to finance its assets. The ratio can also be referred to as financial leverage. The latter is a key metric used by investors when assessing the credit health of a business.

If the ratio is high and keeps rising, creditors are financing the organization rather than its revenue streams. Therefore, it indicates a dangerous financial situation. 

Lenders and investors usually prefer a low debt-to-equity ratio, as the company is better protected from going bankrupt, making investments and loans safer. We can conclude that organizations with a high debt-to-equity ratio will find it hard to attract investors.

Formula is:

Debt-to-Equity Ratio (%) = Total liabilities/ Total Equity * 100

An optimal debt-equity ratio should be 1, i.e., liabilities = equity. Considering the various industries, most companies' maximum acceptable debt-to-equity is 1.5 - 2 or less. 

While large companies can afford a ratio of more than 2, a high ratio is not acceptable for most medium enterprises.

A high debt-to-equity ratio generally indicates that a company finds it hard to generate enough cash to meet its debt obligations. However, a low debt-to-equity ratio could also mean that a business is not benefiting from potential higher earnings brought on by financial leverage.

5. Interest Coverage Ratio (%)

The interest coverage ratio (ICR) measures the ability of a company to meet its interest payments. We calculate it by taking a company's earnings before interest and taxes (EBIT) for a time period greater than one year, divided by interest expenses for the same period.

It indicates the frequency a company can make interest payments on its debt obligations with its available EBIT. The higher the ratio, the better since it signifies that the company can quickly pay interest expenses on outstanding debt.

Formula is:

Interest Coverage Ratio (%) = Profit Before Interest/ Interest Expense

Investors favor a high-interest cover ratio as the company has enough earnings to meet its interest payments. On the other hand, a lower ICR means fewer earnings are available to make interest payments, and the business is more vulnerable to increased interest rates.

For an organization whose ratio is only 1.5 or less, its capacity to meet interest expenses may be questionable. An interest coverage ratio below 1.0 indicates that the business is struggling to generate the necessary cash to cover its interest payments - Interest Payments > EBIT.

Gearing Ratio and Risk

The gearing ratio serves as a crucial indicator for assessing a company's financial health and risk. It represents the proportion of a company's capital structure that is financed through debt relative to equity. A high gearing ratio signals that a significant portion of the company's funding originates from borrowing, potentially leading to elevated financial risk, particularly during economic downturns.

For instance, Company A and Company B, operating within the same industry. Company A exhibits a gearing ratio of 70%, implying heavy reliance on debt for financing, while Company B maintains a gearing ratio of 30%, indicating a more moderate dependence on borrowed funds. In the event of a recession, both companies face financial challenges. Company A, with its high gearing ratio, confronts substantial interest payments, potentially straining its financial stability and facing a heightened risk of bankruptcy if the economic downturn persists.

On the other hand, Company B, with its lower gearing ratio, enjoys enhanced financial stability. It faces fewer interest payments, rendering it better equipped to navigate economic uncertainties. Investors and lenders typically favor companies with lower gearing ratios, considering them less risky due to their diminished reliance on debt financing.

Companies and Financial Gearing

Businesses can look for several ways to decrease their debt-to-equity ratio by using the techniques listed below:

1. Convert loans

Companies can negotiate with their debtors to swap existing debt for shares in their business. Nevertheless, this option should only be used when a business is clearly in a difficult situation and unable to pay off its borrowings.

2. Sell shares

The company's board of directors could give the green light for the sale of shares in the company to meet debt obligations.

3. Reduce working capital

To achieve this, we must increase the rate of accounts receivable collections, reduce inventory levels, and extend the maturity dates of accounts payable. These measures can be used to generate cash and pay down debt.

4. Reducing operational costs

A business can look for areas or segments of its operations that tend to be inefficient in terms of cost. Then, once those operational inefficiencies have been identified, look for ways to reduce them and use the money saved to pay off debt obligations.

For instance, if renting an office building is unnecessary, or staff can work remotely, the organization can look for ways to cut back on those expenses by saving on office rent and office supplies for its employees.

5. Seek alternative financing options

If a business intends to increase its cash flow and depend less on debt financing, debt factoring might be a better alternative. This practice ensures a company gains access to working capital by selling its invoices, effectively avoiding waiting periods and creating liquid capital.

Uses of Gearing

Gearing ratios are used by various stakeholders, including investors, lenders, and company management:

1. Investor Perspective: The gearing ratio is a critical metric for investors to gauge the risk associated with a specific company. A lower gearing ratio indicates greater financial stability and less risk. This ratio aids investors in making informed decisions about their investment choices. For example, risk-averse investors often prefer companies with lower gearing ratios due to the reduced likelihood of encountering financial distress.

2. Lender Assessment: Lenders, such as banks, utilize gearing ratios to assess a company's creditworthiness. A company with a high gearing ratio may encounter challenges in securing favorable loans due to the perceived financial risk. Lenders are more inclined to offer competitive interest rates and lending terms to companies with lower gearing ratios.

3. Strategic Management: From a company's standpoint, the gearing ratio serves as a valuable tool for managing its financial structure. Companies analyze their gearing ratios to ascertain whether they need to decrease debt or increase equity financing to achieve a more balanced and less risky capital structure. For instance, a company with a high gearing ratio might opt to issue new shares to raise equity, thereby reducing its dependence on debt and lowering its gearing ratio.

4. Industry Comparisons: Gearing ratios yield meaningful insights when compared within the same industry. Different industries exhibit varying levels of acceptable gearing owing to their unique capital requirements and risk profiles. Industries such as manufacturing, characterized by high capital intensity, often demonstrate higher gearing ratios due to frequent financing of large, costly assets through debt. Comparing a company's gearing ratio to industry standards provides a more accurate assessment of its financial health and risk profile.

Gearing Limitations

The above ratio is effective when determining whether or not a company is making good use of its capital. In addition, it is of paramount importance for investors since it gives a good indication of whether or not an investment is risky.

If an organization's capital consists predominantly of interest-bearing funds, it is a riskier investment. On the other hand, if the company has a higher proportion of common equity, then it would be a safer investment decision.

One possible drawback of the ratio is that it is not the only determinant for investors when considering whether or not to invest in a company. For example, imagine an individual looking at Company A's capital structure for 2015. It consists of 30% common shares and 70% borrowed funds. 

Since Company A is highly geared, investors will immediately conclude that it is a risky investment simply due to a single ratio. Nevertheless, reviewing the company's capital structure over at least its past 5-6 fiscal years is essential to see if it has been highly geared over that timeframe.

If a company has been highly geared for the past 5-6, we can conclude that it is a risky investment. On the other hand, if this is not the case, and they have taken a loan since they are a young and growing business or to meet an urgent need, an investor might still consider investing.

It is also essential to know that ratio calculations should only be done when comparing companies in the same industry since they tend to be highly industry-specific.

Monopolistic companies are often found to have a high ratio compared to other types of markets. However, even if the ratio indicates that a company is at a high risk of going bankrupt, it might not be the case in relation to other firms in the industry.

Their strong industry position can explain this situation which mitigates their financial risk. Moreover, capital-intensive industries, such as manufacturing, often finance their expensive items via debt which automatically results in higher ratios.

Researched and authored by Alvin | LinkedIn

Reviewed and edited by James Fazeli-Sinaki | LinkedIn

Free Resources

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