Table of Contents
- How to measure gearing
- How to read the gearing ratio
- Is high gearing bad?
- Is low gearing good?
- What to read next
What’s: Gearing shows you how much a company depends on debt in its capital structure. It’s a term in the UK and the same as leverage for the term in the United States.
The company’s capital structure is divided into two sources: debt and equity. Debt represents a liability. Meanwhile, equity represents ownership of the company’s assets.
The company must pay interest regularly and repay it when due. Therefore, gearing shows the extent to which a company’s operations depend on debt instead of equity.
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. Or a combination of the two.
How to measure gearing
There are various ways to measure the gearing ratio. You can use the debt-to-equity ratio. For example, the 2x ratio shows you that the company’s debt is twice the equity. If the company’s debt is $80 million, its equity is $40 million.
Here is the formula for calculating gearing:
Debt capital. The sources can come from bank loans, corporate bonds, and medium terms notes. They can be expensive because the company has to pay regular interest (or coupons) regardless of operating conditions and profits. For debt securities, they must pay off the principal at maturity.
However, suppose the company has paid off the debt. In that case, they still have assets because debt does not represent ownership but a liability. Also, lenders do not have voting rights to influence strategic decisions and company operations.
Capital stock. The company may request additional paid-in capital from the current owners. Or, it can issue shares on the stock market. It doesn’t have to pay it back.
Sure, they pay dividends, but that’s not a requirement. They can choose not to pay dividends. If they don’t pay dividends, they can use the profits to grow the business.
However, the sale of shares to the public resulted in the current owner losing control of the business.
How to read the gearing ratio
There is no ideal gearing ratio for all industries. Good or bad depends on the nature of operations and the stability of cash flow. A stable cash flow allows the company to promptly pay off its obligations, reducing the default risk.
The ratio also changes over time. It usually increases as the company expands. If successful, the company generates more profit and cash inflows in the future. That, in turn, increases retained earnings and shareholder equity, lowering the gearing ratio.
Is high gearing bad?
A company has high gearing when the majority of its funding comes from interest-bearing debt. We consider the company to have a high financial risk.
But, how high the ratio is that we think it is terrible, it varies. It depends on the business nature of the company and the industry in which the company operates.
High leverage is bad because:
First, the company must continue to pay off debts, whether the business generates income or not. Even when revenue equals zero, the company has to pay it anyway.
High financial leverage makes companies vulnerable to business cycle downturns. When the economy worsens, demand falls as consumers save more. They allocate less money to purchase goods and services.
Falling demand worsens company earnings. And, they have no control over the situation and can only adapt.
The decline in sales means less money coming into the company. On the other hand, they must pay for operating expenses such as raw materials, salary expenses, selling expenses, general and administrative expenses. As a result, they find it difficult to pay interest or pay off debts.
Second, shareholders view it with skepticism. The company must pay its debt first before distributing dividends. Payments of interest and principal take up a large part of the company’s profits. It reduces the distribution of earnings as dividends.
Third, lenders and bond investors see high leverage as increasing financial risk. Companies with excessively high debt are likely to default and go bankrupt. Thus, they are reluctant to provide further loans to the company. Or, when they do, they will ask for higher interest to compensate for the higher risk.
The risk is higher when most debt has a variable rate, and interest rates tend to rise. Companies have to spend more money to pay interest and pay off debts.
But, indeed, you cannot judge financial risk only from the high and low gearing ratios in a particular year. You must compare it with other competitors or industry practices. You also have to check the use of debt, whether for productive activities or not.
Tolerance for debt levels varies between industries. Some industries have high and tolerable gearing ratios. They have relatively stable cash inflows, so that their ability to pay debts is also good.
Take, for example, the power companies. 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. Whether there is a crisis or not, consumers will still pay their electricity bills.
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. By doing so, they can produce and sell more products. They can use the additional income to pay interest and pay off debts.
Conversely, suppose the company doesn’t take on debt. In that case, they may miss an opportunity to grow the business by taking on lucrative projects. Finally, the firm is in an uncompetitive position because its size is not growing, making competitive capacity low.
Is low gearing good?
Companies have low gearing when most of their capital comes from equity. They are considered financially stable. They have a low financial risk. During periods of low profit and high-interest rates, companies are less vulnerable to default and bankruptcy risk.
That may indicate conservative financial management. 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.
What to read next
- Types of Financial Ratios: Their Analysis and Interpretation
- Activity Ratio: Types, Formulas, and Interpretations
- Liquidity Ratio: Examples, Formulas, How to Calculate
- Solvency Ratio: Formulas, Examples, and Calculations
- Profitability Ratio: Formulas, Types, and Examples
- Valuation Ratio: Formula And Its Interpretation
- Gearing: Meaning, How to Calculate, Pros and Cons
- Financial Ratios For Credit Rating Analysis
- Cash Flow Ratios: Examples, Formulas, and Interpretations
- DuPont Analysis: Formula, Decomposition, Interpretation, Pros, Cons