Gearing Ratio: Formula, Calculation, And more

kh.nour 0 Comments July 26, 2021

Comparing gearing ratios of similar companies in the same industry provides more meaningful data. For example, a company with a gearing ratio of 60% may be perceived as high risk. But if its main competitor shows a 70% gearing ratio, against an industry average of 80%, the company with a 60% ratio is, by comparison, performing optimally. Gearing is the amount of debt – in proportion to equity capital – that a company uses to fund its operations. A company that possesses a high gearing ratio shows a high debt to equity ratio, which potentially increases the risk of financial failure of the business. Regulated entities typically have higher gearing ratios as they can operate with higher levels of debt.

How to Calculate Gearing Ratio

Such investments require urgent action and shareholders may not be in a position to raise the required capital, due to the time limitations. If the business is on good terms with its creditors, it may obtain large amounts of capital quickly as long as it meets the loan requirements. Putting all of this together allows us to measure how leveraged a company is i.e. how much debt it has compared to equity.

Good and Bad Gearing Ratios

Further, the cost of debt is lower than equity due to tax advantage. However, a complete assessment needs to be made based on an overall financial statement and relevant business conditions. Three ratios used in the financial analysis include profitability, liquidity, and gearing. This metric connectively analyzes profitability and gearing aspects.

Reduce Working Capital

Accountants, economists, investors, lenders, and company executives all use gearing ratios to measure the relationship between owners’ equity and debt. You often see the debt-to-equity ratio called the gearing ratio, although technically it would be more correct to refer to it as a gearing ratio. The gearing and solvency ratios are similar in that they both measure a company’s ability to meet its long-term financial obligations.

What is Compound Annual Growth Rate (CAGR)?

  1. A company with a low gearing ratio is generally considered more financially sound.
  2. Striking the right balance between debt and equity is crucial for optimizing capital structure and sustaining long-term growth.
  3. Putting all of this together allows us to measure how leveraged a company is i.e. how much debt it has compared to equity.
  4. Lastly, they can restructure or refinance their debt to secure more favorable terms, potentially lowering the overall debt level.

A profitable company can use borrowed funds to generate more revenues and use the returns to service the debt, without affecting the ownership structure. cost benefit analysiss reflect the levels of risk involved with the company. Capital that comes from creditors is riskier than money from the company’s owners since creditors still have to be paid back even if the business doesn’t generate income.

Gearing Ratio vs. Debt-to-Equity Ratio: What’s the Difference?

Furthermore, if companies can allocate debt for productive investment, they can create more income in the future. They can use it to purchase capital goods, build production facilities, acquire other companies, and add new products and services. They can use the additional income to pay interest and pay off debts. Even though they tend to have high gearing, they can still secure cash inflows. They usually operate under a monopoly market and thus have substantial market power. Their income streams are also resistant to business cycle fluctuations, so they are relatively stable.

Example of How to Use Gearing Ratios

All companies have to balance the advantages of leveraging their assets with the disadvantages that come with borrowing risks. This same uncertainty faces investors and lenders who interact with those companies. Gearing ratios are one way to differentiate financially healthy companies from troubled ones.

Companies may not be able to maximize growth opportunities by taking on debt. On the other hand, shareholders may expect the company to pay dividends regularly. First, the company must continue to pay off debts, whether the business generates income or not.

To reduce the gearing ratio, companies can pay off debts more quickly. The company can also sell its initial public offering or rights issue when it has previously done so. If we write out the formula, we can say that a gearing ratio is the total amount of debt divided by the amount of capital provided by shareholders.

The board of directors could authorize the sale of shares in the company, which could be used to pay down debt. Amanda Bellucco-Chatham is an editor, writer, and fact-checker with years of experience researching personal finance topics. Specialties include general financial planning, career development, lending, retirement, tax preparation, and credit. Suppose a company reported the following balance sheet data for fiscal years 2020 and 2021. If they don’t pay dividends, they can use the profits to grow the business.

The main aspects of the business include profitability, liquidity, activity, and gearing. A good business manager has the competence to manage all of these aspects and ensure the efficient running of the business. Understanding the concept of the gear ratio is easy if you understand the concept of the circumference of a circle—the distance around the circle’s perimeter. It directly influences a company’s cost of capital, impacting profitability and financial flexibility.

However, the solvency ratio also considers a company’s cash flow, which is its capacity to produce sufficient funds for immediate and long-term commitments. You can calculate this ratio by dividing a company’s after-tax net operating income by its total debt obligations, providing a more comprehensive picture of its financial health. Gearing ratios offer insightful perspectives into a company’s capital structure and financial risk. A company’s gearing ratio is used by a wide range of stakeholders, including investors, lenders, and analysts.

While the figure gives some insight into the company’s financials, it should always be compared against historical company ratios and competitors’ ratios. However, it can be of use when the bulk of a company’s debt is tied up in long-term bonds. Lenders are particularly concerned about the gearing ratio, since an excessively high gearing ratio will put their loans at risk of not being repaid.

However, it could also indicate a lack of growth opportunities, as companies often use equity financing when not investing heavily in new projects. Therefore, gearing ratios are not a comprehensive measure of a business’s health and are just a fraction of the full picture. Make sure to use gearing ratios as part of your fundamental analysis, but not as a standalone measure and always utilise the ratios on a case-by-case basis.

It calculates the proportion of a company’s debt compared to equity. A higher ratio indicates higher financial risk yet potentially higher returns. Conversely, a lower net gearing ratio may signify financial stability but potentially lower returns. Finding the optimal gearing ratio helps investors understand a company’s financial health and risk level. The gearing ratio measures a company’s financial leverage as a percentage. In simpler terms, it shows how much a company relies on borrowed money to finance its operations and growth.

This might indicate a financial hazard for the company, as it must make enough profits to meet its debt obligations. However, it could also signal growth potential, as companies often take on debt to invest in new projects or acquisitions. As shown by the table above, Walmart has reduced debt in its capital structure over the last five years, from 74% of the equity in 20X4 to just 60% of the equity in 20X8. Find out how to calculate a gearing ratio, what it’s used for, and its limitations.

Companies may also opt for equity financing over debt for new projects. Furthermore, improving operational efficiency to increase profitability can help service existing debts. A low gearing ratio suggests that a company is primarily financed by equity. This could signify financial stability, as the company relies less on external financing.

This ratio provides a measure to which degree a business’s assets are financed by debt. The net gearing ratio is the most common gearing ratio used by analysts, lenders, and investors. Also called the debt-to-equity ratio, it measures how much of the company’s operations are funded by debt compared to its equity.