The gearing ratio is also a crucial financial indicator that can be used to assess a firm's capital structure by comparing its debt to equity. It indicates the proportion of the company's financing that comes from borrowed money and shareholder capital. The gearing ratio is crucial for business owners, investors, and analysts because it reveals the degree of financial risk and stability that a company faces. A balanced level of gearing ratio seems to denote a well-balanced proportion between debt and equity. Its high or very low level may raise apprehension.
Read further to learn what gearing ratio is, how it is measured, and why it matters across differing industries and scenarios.
What is the Gearing Ratio?
The gearing ratio is a tool employed to comprehend the extent to which a company relies on borrowed capital compared to its own capital. It displays the ratio of debt over equity, allowing us to observe to what extent the business is financed through loans rather than shareholders' capital.
If a company has a high gearing level, it implies that it has borrowed a great deal. This will imply financial risk, depending on the sector. Certain businesses, such as those in the utilities or infrastructure sectors, tend to use more debt, whereas others in volatile markets prefer less.
Formula of Gearing Ratio
The common formula is:
Gearing Ratio = (Total Debt / Shareholders’ Equity) × 100
Example:
If a company has ₹10 crore in debt and ₹25 crore in equity:
(10 / 25) × 100 = 40%
This means 40% of its operations are funded by debt.
How to Calculate Gearing Ratio?
Add up all the company’s debts (both short- and long-term).
Calculate shareholders’ equity (total assets minus total liabilities).
Use the formula: (Total Debt / Shareholders’ Equity) × 100
Read the result as a percentage, it reflects how much the company relies on debt.
Good and Bad Gearing Ratios
A good ratio is determined by the industry and the company's strategy. Normally, if gearing is below 50%, that's quite a good position. It indicates that the business does not rely heavily on borrowed funds.
However, some industries tend to have naturally higher gearing ratios. For example, capital-intensive industries such as power or telecommunications might have more debt on their books, as they also have stable revenue streams. Conversely, organisations dealing in cyclic industries might prefer low gearing to remain agile during downturns.
Additionally, the cost of borrowing is a significant factor. A company with high gearing might not face problems if it gets low-interest loans. Companies with low gearing might still struggle if they must borrow at high interest rates.
Good Gearing Ratio:
Typically, a ratio between 25% and 50% is regarded as good. It depicts a healthy proportion of equity and debt. It enables the company to utilise borrowed funds with effectively managed risks. Healthy gearing brings tax savings on interest payments and improved returns.
Bad Gearing Ratio:
Anything above 50% can be risky, especially if it’s not common in that industry. This means the company is heavily reliant on debt, which can be hazardous if cash flow declines or interest rates rise. This could even lead to financial trouble or bankruptcy. On the other hand, very low gearing could mean the company isn’t taking advantage of opportunities to grow using leverage.
Pros & Cons of Gearing Ratio
It is crucial to weigh the pros and cons of gearing before you can use the tool to its potential.
Benefits of Gearing Ratios
Gearing ratios enable lenders and financial institutions to quickly assess the risk associated with lending to a company. A high gearing ratio typically indicates a greater risk of financial difficulties or even bankruptcy.
For businesses, it’s a handy tool to track their debt levels, plan future cash flow, and manage their financial leverage more effectively.
Drawbacks of Gearing Ratios
However, gearing ratios do have limits. A high ratio might suggest financial risk, but it doesn’t always mean the company is struggling. The ratio alone doesn’t tell the full story. It’s more useful when compared to past data or to other companies in the same industry.
Who Uses Gearing Ratios in Financial Analysis?
Gearing tools can be effectively used by the following:
Banks and lenders examine gearing ratios to determine whether to extend loans. Since their goal is to earn interest payments, they want to ensure that a borrower can repay them.
Startups with high gearing often get rejected because they carry higher financial risk. But some firms, like those in energy or utilities, can handle higher debt due to the steady nature of their business.
Investors also consider gearing ratios when evaluating a company. A low gearing ratio typically indicates that the company is on solid financial footing, which can attract more investment. If a company already has a significant amount of debt and is paying high interest, potential investors might hesitate, fearing that their money won’t generate good returns or could be at risk.
Gearing ratios are particularly useful when comparing similar companies. A single number might appear risky on its own, but when viewed alongside others in the same sector, it can tell a different story.
For instance, if a firm has a gearing ratio of 60%, it may seem high. But if competitors are operating at 70% or 80%, that 60% suddenly looks more reasonable and even competitive.
How to Control and Manage the Gearing Ratio Effectively?
To reduce their gearing ratio, companies need to decrease the amount of debt they owe. Here are a few common ways they can do that:
By selling additional shares to the public, a company can raise capital and increase its equity, which can then be used to repay debt.
Sometimes, companies work out deals with lenders to turn existing loans into shares, reducing their outstanding debt.
Lowering everyday costs by eliminating inefficiencies can free up cash that can be used to pay back loans.
Focusing on strategies to increase revenue can lead to higher profits, allowing the company to reduce its debt load with more financial resources.
Conclusion
Gearing ratios are helpful for anyone looking to understand a company’s financial position, whether it’s a lender, investor, or the business itself. They demonstrate the extent to which a company relies on borrowed money and help assess the level of financial risk.
Still, it’s essential not to rely solely on this ratio. It’s rather useful when viewed over time and compared with industry peers. Together with other financial indicators, gearing ratios offer a clearer picture of a company’s overall health.