A calculation method dear to many financial analysts, a gearing ratio is a real thermometer for assessing the financial health of a company. This financial ratio is used as much by investors as bankers or business executives. What is a gearing ratio and what is it used for? How is it calculated? What is the recommended total debt to equity ratio? Is it better to have a high or low debt to equity ratio? Agicap reviews the concept of gearing ratios.
Gearing Ratio Defined
One way to understand how a company is financed is to assess its total debt to equity ratio. Also called a gearing ratio, this is the amount of debt vs. equity that a company uses to finance its operations.
A gearing ratio therefore allows the respective weight of total financial debt and equity to be assessed. In other words, a gearing ratio is a tool for measuring the solidity of a company's financial structure and its ability to repay its debts with its equity in the event of a problem. Often used by financial analysts, a gearing ratio acts as a "thermometer" of the financial health of a company.
Gearing or debt to equity ratio = total debt / equity
A high debt to equity ratio means a high leverage effect for a company. It is therefore more sensitive to any slowdown of the economy. In contrast, a company with a low debt to equity ratio is generally considered to be financially more sound.
Note that in addition to the debt to equity ratio, there are several debt ratios that compare a company’s equity to its borrowed funds. These include the capital ratio, the debt to capital ratio and the debt service ratio.
What is the purpose of a gearing ratio?
A gearing ratio clarifies the source of financing for operations in a company. The main advantage lies in gaining a better idea of its reliability and ability to weather periods of financial instability. In this sense, the higher the debt to equity ratio, the more dependent the company is on its third parties.
The gearing ratio method can benefit three main players:
- Bankers
- Investors
- Business executives
Benefits of a Gearing Ratio for Bankers
For an investor, the debt to equity ratio is one of a number of tools used to calculate whether a company is a viable investment. It helps shed light on a company’s profile (cautious, aggressive, etc.) and can give an indication of its competitiveness compared to its direct competitors.
Investors are usually more attracted to companies with a low debt to equity ratio. Why? Because a company with a high gearing ratio already pays high interest rates to its lenders. Investors are aware of potential default risks and may therefore be more reluctant to invest their money.
Benefits of a Gearing Ratio for Business Executives
For business executives, a debt to equity ratio is probably one of the most important indicators of the financial health of their company. In addition to assessing their dependence on banks, a gearing ratio measures their capacity to incur debt from them.
If you are a business executive, keep in mind that you have the possibility of using loans to finance your company's operations. Additional money brought in from loans can allow you to expand your business, win over new markets or launch new products. Ultimately, you will increase your long-term profitability, which will automatically reduce your gearing ratio.
Calculating the Gearing Ratio (or Debt to Equity Ratio)
Unlike other financial ratios, a gearing ratio focuses more on the concept of financial leverage than on the exact ratio calculation. To calculate it, simply add up the long- and short-term debts then divide them by the equity.
Gearing Ratio Formula:
Gearing or Total Debt to Equity Ratio = total debt / equity
The gearing ratio is composed of the following elements:
● Total debt = external resources (short-term and long-term financial debt + shareholder current accounts) minus available assets (cash and securities).
● Equity = company’s own resources (capital and shareholder contributions, reserves from reinvested profits, total profits or losses for the financial period).
As a general rule, the debt to equity ratio is converted to a percentage by multiplying the fraction by 100 in order to obtain the total debt to equity ratio. This gives the following formula:
Total Debt to Equity Ratio = (total debt / equity) x 100
If the company has no shareholders, then the owner is the sole shareholder. The equity is therefore its own.
Note that long-term debt means loans, leases or any other form of debt for which payments must be made at least one year in advance. Conversely, short-term debt requires payment within one year.
Why analyse the gearing ratio?
Unlike certain financial calculation methods, it is important to understand that a debt to equity ratio is more of a comparison tool than an independent calculation. It is mainly used to determine a company’s performance in relation to another company or companies in the same sector. Two approaches are therefore necessary for a gearing ratio:
- The Relative Approach: i.e. taking into account companies from the same sector and at the same stage in their development to compare gearing ratios.
- The Time-Based Approach: i.e. understanding successive analyses over time, throughout the development of a company.
High Gearing Ratio
A gearing ratio of more than 60% is considered to reflect high dependency of a company on external capital to finance its investments and operations. Above 66%, the company enters a red zone. In this case, it is considered to be highly in debt.
It is completely acceptable for a gearing ratio to be above 80% for a short period of time. This may indicate, for example, that the company has taken advantage of a fall in interest rates to take out a loan, rather than drawing on its reserves.
Low Gearing Ratio
A gearing ratio below 50% is considered a low gearing ratio. To some analysts, this may be an advantage as a company with little debt has more room for manoeuvre if it ever needs financing, especially if the creditors do not threaten its independence.
Below 25%, on the other hand, a company may not be able to take advantage of expansion opportunities when interest rates are low. It would then miss out on growth opportunities that its competitors would undoubtedly not hesitate to seize.
The gearing ratio depends on the sector of business
High or low gearing ratio: to establish the optimal gearing ratio level, it is necessary to first make comparisons within the company's sector.
For example, a company with a gearing ratio of 70% could be seen as presenting a high risk. But if its main competitor has a gearing ratio of 80%, and the sector average is 85%, then the performance of the company with a 70% ratio is optimal in comparison.
This illustration is relevant in the industrial sector for example. These companies are more likely to resort to loans to finance their often considerable investments. In the short term, the gearing ratio can therefore "soar" by going above 1 (or 100%). But if an industrial company generates sufficient cash flow to repay this debt, the gearing ratio will gradually decrease to reach an acceptable rate.
Conversely, companies with a high fixed cost structure or whose situation is uncertain normally have a lower gearing ratio.
Analysing the Gearing Ratio Over Time
The last decisive factor in analysing the gearing ratio is time. The gearing ratio usually decreases as a company develops.. If business is going well, the company will generate more profits and cash flow in the medium- to long-term. Retained earnings and equity will increase, which will automatically lower the gearing ratio.
The company’s situation can also have a considerable impact on the gearing ratio. For example, if a company has just made a major acquisition, a ratio higher than 1 would be momentarily acceptable before tending towards a much lower level.
Example of a Gearing Ratio Calculation
If your company has debt of €100,000 and your balance sheet shows €75,000 in equity, your gearing ratio would be equivalent to 133% (relatively high ratio).
The formula: (100,000 / 75,000) x 100 = 133.33%
Now, let's say you want to raise money by issuing shares. You succeed in raising €50,000 by offering shares. In this case, your equity increases to €125,000 (€75,000 starting point + €50,000 from shares).
The new formula: (100,000 / 125,000) x 100 = 80%
Your gearing ratio drops to 80%.
Gearing Ratio and Bank Covenants
Debt covenants, also known as bank covenants or financial covenants, are the terms and conditions agreed between creditors and a company as part of a loan agreement. These provisions aim to guarantee the rights of the lender and to prevent possible defaults.
In most countries, France included, covenants set limits for debt. As a gearing ratio is a method of assessing debt, a company is sometimes required to maintain a certain level of debt, otherwise the lender can assert its rights (up to and including immediate repayment of the capital borrowed). Failure to comply with a guideline is known as a "breach of covenant".
These bank covenants are generally defined according to market conditions, the characteristics of the debt (secured or unsecured) and the financial stability of the company.
In addition to a debt ratio limit, a lender may impose additional requirements, such as a maximum level of interest coverage, a minimum working capital or the inability to buy back shares until the debt is repaid.
How to Reduce the Gearing Ratio
To reduce the gearing ratio, several solutions are available to business executives. Here are a few of them.
1. Correctly Manage Debt
This is perhaps the most obvious solution, but not always the easiest to implement. If a company efficiently manages its debt, it should be capable of reducing its total debt to equity ratio. Companies can take measures to repay their debt and incur less interest in the long-term such as renegotiating the terms of the debt with their lenders. Over time, this method can reduce liabilities.
2. 2. Increase Profits
Increasing profits contributes to increasing share prices and therefore equity. On the other hand, taking out loans can sometimes help a business to become more profitable in the long term. Reduce Spending
By reducing spending, you decrease your liabilities and therefore your debt to equity ratio. This may include renegotiating loan terms, making the company more efficient and introducing basic cost control.
To reimburse part of your debt, your board of directors may authorise the sale of company shares. This option, which is seldom used by companies, can sometimes pay off up to 30% of debt.
4. Convert Debt
As another possibility you can negotiate with your lenders to swap the existing debt for shares in the company.
5. Reduce the Working Capital Requirement
Finally, try to increase the speed of recovery from debtors or negotiate the extension of payment terms with your suppliers.
The Limits of Gearing Ratios
Although gearing ratios are widely used, certain limitations are worth mentioning.
● Firstly, like any financial analysis method, a gearing ratio is not sufficient in itself. This result must be cross-checked with other calculations to really understand a company’s financial health.
● For instance, the total debt to equity ratio can reflect a risky financial structure without actually indicating a poor financial situation. Remember that this figure must always be compared to the company’s historical financial data and that of its competitors. Taken independently and only at a given moment in time, the debt to equity ratio will only be of relative importance.
For example, for a monopoly or quasi-monopoly, it is normal for a company to have a higher debt to equity ratio, as the financial risk is mitigated by its dominant position in the sector. Similarly, capital-intensive industries generally finance expensive equipment with debt, resulting in debt to equity ratios often exceeding 80%.
This is why it is important to take into consideration a company’s sector of activity when analysing its gearing ratio, as standards vary depending on the type of business.
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