Gearing (or leveraging) is a term that can take some getting used to within the context of financial planning. It’s worth spending a moment to understand what gearing is trying to do – and why it is, in fact, about gears.
What is gearing ratio?
A gearing ratio is a financial metric used to assess a company’s financial leverage. It compares a company’s total debt to its equity and provides an indication of how much of a company’s operations are financed through debt vs through equity.
A high gearing ratio indicates that a company has a significant amount of debt relative to its equity. This can increase the financial risk of the company, as higher levels of debt mean higher interest payments and potential difficulties in servicing that debt. On the other hand, a low gearing ratio indicates that a company is primarily financed through equity and is therefore less financially leveraged.
Why is it called gearing ratio?
The term “gearing” comes from the idea of using gears to achieve greater power or force. In the same way, a company can use debt to increase its financial leverage and potentially generate greater returns for its shareholders.
The term “gearing ratio” is commonly used in the UK and other Commonwealth countries, while the term “leverage ratio” is more commonly used in the United States. Both terms are used interchangeably to describe the same concept.
What is a good gearing ratio?
In general, a gearing ratio of 1:1 or less is considered conservative, indicating that the company has more equity than debt. A ratio of 2:1 or more is considered risky, indicating that the company has more debt than equity. However, there is no universally accepted “good” or “bad” gearing ratio, as the optimal ratio varies depending on the company’s specific circ*mstances.
For example, companies in capital-intensive industries, such as manufacturing or utilities, typically have higher gearing ratios than those in service industries, as they require more debt to fund their operations. Additionally, companies in growth stages may have higher gearing ratios to fund their expansion plans.
Ultimately, the ideal gearing ratio for a company depends on its individual circ*mstances, risks, and financial objectives. Companies should carefully consider their debt-to-equity ratio when making financial decisions and seek the advice of financial professionals.
What is a bad gearing ratio?
A bad gearing ratio is one where a company has excessive debt in comparison to its equity, which can lead to financial instability and higher risk of default. A high gearing ratio means that a company is relying heavily on borrowed funds to finance its operations, which can be problematic if the company’s cash flow decreases or interest rates rise.
Generally, a gearing ratio of above 50% is considered high and could be seen as a bad gearing ratio. However, what is considered a bad gearing ratio can vary depending on the industry, the stage of the company, and other factors. It is important to evaluate the gearing ratio in the context of the company’s overall financial health and its ability to generate sufficient cash flow to service its debt obligations.
How do you calculate gearing ratio?
The formula for calculating the gearing ratio is as follows:
Gearing Ratio = Total Debt / Total Equity
Here, total debt includes both short-term and long-term debt, such as loans, bonds, and other borrowings. Total equity includes the value of all the assets owned by the company minus all the liabilities.
For example, if a company has total debt of $1 million and total equity of $2 million, the gearing ratio would be calculated as:
Gearing Ratio = 1,000,000 / 2,000,000 = 0.5 or 50%
This means that the company has a gearing ratio of 50%, which indicates that it has more debt than equity. A higher gearing ratio implies a higher level of financial leverage and can indicate greater financial risk for the company.
Debt to Equity Ratio
Also called the Debt to Total Assets ratio. This ratio is usually expressed as a percentage. This measures a company’s ability to meet its obligations (liabilities) through its assets.
Debt Ratio = Total Debt (Liabilities) / Total Assets
The higher the percentage of debt to total assets, the higher the potential risk of the company not being able to meet its obligations.
Again, different industries can have very different ‘normal’ values for the debt ratios. Stable industries or very well established companies tend to have higher debt ratios.
Times Interest Earned (TIE)
This ratio looks at the company’s ability to pay the interest on its debts. This is often calculated over a year, to see how many times over the company can afford to pay the interest due on its debts in that year.
Times interest earned = Earnings Before Interest and Taxes (EBIT) / Interest Payable on Debts
Generally, a low TIE ratio is bad, and a high one is good. A low ratio shows that the businesses’ earnings may not be able to cover its debts, while a high ratio shows that the business’ earning can cover its debts many times over.
Equity Ratio
This ratio shows how much money shareholders will receive if a company liquidates its assets. It is expressed as a percentage.
Equity Ratio (Shareholder Equity Ratio) = (Shareholder Equity + Retained Earnings) / Total Assets
Shareholder Equity, Retained Earnings and Total Assets can be found on the balance sheet. When forecasting this ratio, a higher ratio indicates that investors can expect a greater return should a company liquidate its assets.
Do note that if a company goes bankrupt it pays debtors before shareholders!
Debt Ratio
Also called the Debt to Total Assets Ratio. This ratio is usually expressed as a percentage. This measures a company’s ability to meet its obligations (its liabilities) through its assets.
Debt Ratio = Total debt (Liabilities) / Total Assets
The higher the percentage of debt to total assets, the higher the potential risk of the company not being able to meet its obligations.
Again, different industries can have very different ‘normal’ values for the debt ratios. Stable industries or very well established companies tend to have higher debt ratios.
How to reduce gearing
There may be an instance in which you’d like to reduce your gearing ratio and decrease the level of debt used to finance a company’s operations or investments. Here are some ways to reduce gearing:
Retain earnings
A company can reduce its gearing by retaining using earnings to finance its operations and investments instead of relying on debt financing. By retaining earnings, a company can also strengthen its financial position and increase its borrowing capacity in the future.
Sell assets
Selling non-core assets can help a company raise funds and reduce its gearing. This approach is especially useful for companies that have assets that are not generating significant returns.
Learn more: What are assets?
Issue new equity
A company can reduce its gearing by issuing new equity shares to investors. This approach is also known as equity financing. By issuing new equity shares, a company can raise funds without incurring any debt.
Refinance debt
A company can refinance its existing debt to reduce its gearing. This approach involves replacing high-interest debt with lower-interest debt. Refinancing debt can reduce the overall debt burden and lower interest expenses, which can improve a company’s financial position.
Decrease dividend payments
A company can also reduce its gearing by decreasing dividend payments to shareholders. By retaining more earnings, a company can reduce its reliance on debt financing and strengthen its financial position.
Restructure operations
A company can also reduce its gearing by restructuring its operations to reduce costs and increase profitability. By improving its operational efficiency, a company can generate more cash flow and reduce its reliance on debt financing.
Can you calculate gearing ratios in financial forecasting tools?
Many financial forecasting tools offer features that allow users to input financial data and automatically calculate gearing ratios. This can help investors and analysts make informed decisions about investments and assess the risk associated with different companies or industries.
However, it is important to note that gearing is a complex financial concept and should not be relied upon as the sole measure of a company’s financial health. Other factors, such as the quality of management, industry trends, and economic conditions, should also be taken into account when making investment decisions.
Gearing is an important concept in finance, and financial forecasting software can be a useful tool for calculating and analyzing gearing ratios. However, it is important to use this information in conjunction with other factors and to seek professional advice when making investment decisions.
