Gearing Ratios: Meaning, Types, and How to Calculate

1. Introduction to Gearing Ratios

The gearing ratios are the financial parameters employed in the evaluation of the financial leverage of a company. They show the extent of funding of operations of a firm through debt financing versus equity financing. Putting it in a simpler terminology, gearing indicates the proportion of money borrowed (debt) and the capital (equity) of the owner of the business.

A high gearing level implies that the company uses a lot of leverage in its capital structure whereas low gearing level indicates that the company uses more shareholder funds. The level of gearing in a company is imperative to understand since it has an influence on risk, return, and financial stability.

2. Importance of Gearing Ratios in Finance

Gearing ratios play a very important role in financial analysis particularly in the analysis of a risk profile of a company. These ratios are closely watched by creditors, investors and analysts as they provide an opinion as to whether a company is able to fulfill its long-term obligations and the vulnerability of the company to fluctuations in interest rates or economic times.

The leverage effect can lead to high returns in highly geared firms during the good times but it will also increase the risk of the firm going into insolvency during bad times as a result of the fixed financial obligations such as the payment of interest. Lowly geared companies on the other hand are normally more stable but with less growth potentiality.

3. Capital Structure and Gearing

Capital structure is the funding of operations of a given firm with various sources of finance- primarily equity (owner capital) and debt (borrowed capital). Gearing is basically the proportion between the two.

A balanced capital structure allows a company to enjoy the tax savings and other advantages that come with debt without getting overwhelmed by too many financial demands. The gearing ratios provide a stakeholder with an understanding of whether a company is using its capital effectively.

4. Types of Gearing Ratios

There are different types of gearing ratios and these are utilized in assessing financial structure of a company. They are all about various factors of debt versus equity:

a. Debt-to-Equity Ratio

It is the favourite gearing ratio. It compares the total debt with the shareholders equity. The higher the ratio, the more the debt compared to equity that means the more the financial leverage and risk.

b. Equity Ratio

The ratio looks at the percentage of the total assets of a company which has been funded by the shareholders equity. The decrease in equity ratio indicates that the company is using increased amount of debt.

c. Debt Ratio

It shows the degree of the debt financing of the total assets. The increase in the debt ratio shows that the company has more money on borrowed basis to finance its assets.

d. Interest Coverage Ratio

It is not, strictly speaking, a gearing ratio, but it frequently appears in relation to gearing analysis. It shows the ease with which a firm can pay the interest on the current debt. A lower ratio means that interest payments are harder to make.

e. Capital Gearing Ratio

The ratio helps to calculate the proportion of fixed-interest or fixed-dividend bearing funds (preferably long-term loans and preference shares) to the equity shareholders’ funds. It gives a specific view of financial responsibility that an establishment must settle regardless of the profit magnitude.

5. High vs. Low Gearing

High Gearing

A highly geared company is the one where a great part of capital is provided by debt. Although this can increase returns on equity in profitable periods it also increases financial risk. A highly geared company is more vulnerable to increases in interest rates and fall in turnover.

Low Gearing

Low gearing means that a business is less geared with a conservative capital structure making greater use of shareholders’ funds. Such firms tend to be more financially secure but may lack the leverage effect that enhances the returns in the case of a good market performance.

6. Factors Influencing Gearing Decisions

The reasons that prompt a company to become more or less geared are several:

·       Business Stability: predictable cash flows allow stable businesses to increase debt.

·       Industry Practices: Certain industries such as utilities are just highly geared.

·       Cost of Capital: Companies may find borrowing cheap when all debt is less expensive than equity.

·       Tax Considerations: Debt interest is tax deductible and therefore debt financing is appealing.

·       Expansion Plans: rapidly expanding companies may increase gearing to fund growth.

7. Implications of Gearing Ratios

For Investors:

Investors and gearing ratios: interpret risk. A highly geared company can give better returns, but poses the risk of bankruptcy in an economic crunch. Companies that are less geared are favoured by the conservative investor.

For Creditors:

Gearing is looked at by lenders prior to the provision of loans. The high gearing can be an indication of possible default risk leading to lenders charging a higher interest, or cutting credit limits.

 

 

For Management:

Gearing analysis helps the management to strike the right balance between expansion and financial security. An optimal amount of gearing enhances the valuation and credit quality of a business, though excessive gearing (either high or low) may be a cause of concern.

8. Gearing in Practice

In practice in corporate finance, businesses keep track of their levels of gearing. They can also re-gear their debt, or issue equity capital to alter their gearing ratios in accordance with financial objectives and market circumstances.

A company may issue additional shares, as an example, to decrease its debt/equity ratio particularly when the cost of interest is escalating. Alternatively, a company may choose to borrow to finance expansion in a low-interest rate environment than issue equity and dilute ownership.

9. Conclusion

Gearing ratios give a clear image of how a company funds its business and also the amount of risk the company has due to debt. Through gearing analysis, interested parties get to make decisions on the financial makeup, health, and viability of a business enterprise. As a person getting into corporate finance or investment analysis, learning these ratios is important, as they weigh into decisions as diverse as capital budgeting, risk management and shareholder returns.

There is a balancing act to keep the gearing ratio at an optimal level because excessive debt may result in insolvency whereas low levels may impede growth. Therefore, gearing ratios are very useful in maintaining financial discipline and strategic financial planning.