Finance Tutorials – Page 3

The Gearing Ratio is a fundamental formula that is used everyday by financial analysts, banks and investors to understand the capital structure of a company. The financial gearing shows how much debt a company has compared to the funds that the shareholders have injected. Shareholder funds are not interest bearing but they dilute the ownership of the company. In addition, investors expect some kind of return on their investment which usually takes the form of dividends. On the other hand, debt does not dilute the ownership but it requires interest payments. In addition, debt holders come first when a company is being liquidated. Finally, debt usually requires a fixed or floating charge. Gearing Ratio Formula There are two different formulas that can be used. Both of them are valid and as long as there is consistency, the results from your analysis should be comparable. The first formula includes the interest bearing debt in the numerator and the share capital plus the retained earning in the denominator. So, the first formula for the gearing ratio is: Gearing Ratio (%) = (Interest Bearing Short and Long Term Debt/Share Capital+Retained Earnings) x 100% The second formula that can be used to calculate the gearing ratio is pretty much the same apart from the fact that the debt that is included in the numerator is also added in the denominator. In other words, the formula is: Gearing Ratio (%) = (Interest Bearing Debt)/(Share Capital + Retained Earnings+Interest Bearing Debt) Where interest bearing debt one should include bank loans, overdraft facilities, loan notes issues and other forms of debt that has been issued. Gearing Ratio Examples In order to understand the gearing ratio, two examples will be used. Example 1 Company A has a $1,000,000 bank loan that is due in 5 years. In addition, the shareholders funds as per the latest statement of financial position appear to be $750,000. Similar companies in the industry usually have a gearing ratio of 40% to 50%. Using the above formulas (the first one), we can calculate the gearing ratio for this company which is 75% (1,000,000/750,000). Apart from analyzing the historical data for the same company, it's also useful to compare the results with similar companies in the sector. The reason for that is that different sectors have different characteristics. For this example, we can see that Company A has higher gearing since other companies in this sector have around 50% financial gearing. Example 2 Company B operates in the same sector with Company A. Company B has a $500,00 bank loan and $1,500,000 shareholder funds. Therefore, we can calculate the gearing ratio which is 33.33%. Analysis and Interpretation the While for simplicity, we don't use historical information for Company A and B, we can say that both companies could improve their financial leverage. For example, Company A is highly geared with the gearing ratio being higher than the industry average by 25%. At the same time, company B has a significantly lower than the industry financial leverage. So what does that mean? For company A, a high gearing ratio means that the company will have to pay interest on an annual basis (higher than what's normally paid by same companies in the sector), adhere to bank covenants and risk breaking these covenants when the financial results are not so good. Of course, all of the above are not ideal for a company. Increased gearing ratios are risky and when a company is unable to repay it's debt, it can lead to bankruptcy. At the same time, Company B has a very low gearing ratio when compared to other similar companies in the same industry. This is also not ideal since the cost of debt is lower than the cost of equity. The cost of debt is cheaper because as already mentioned, debt holders are more secured then shareholders (in the event of a liquidation). Of course, as we saw from the first example, that does not mean that companies should only raise debt. This is also risky and can lead to unpleasant events. Companies should find a balance that is in line with the needs of the company, the ability to raise debt or capital (creditworthiness), the needs and desires of its shareholders and also in line with the industry and market standards. How to Increase the Gearing Ratio As explained above, there are reasons for which a company might want to increase the gearing ratio. There are different ways to achieve that: Raise additional debt (bank loans, loan notes, overdraft etc.)Buy Back part of the shares that are issuedPay Dividends from the retained earnings reserves How to decrease the Gearing Ratio Similarly, there are situations where a company might have to or want to lower the financial gearing which can be done by: Repaying part of its interest bearing debt (by selling unused assets or by using cash reserves)Issuing new shares which can be also used to repay bank loans or buy back loan notes which can be then cancelled. Gearing Ratio Online Calculator Finally, a gearing ratio online calculator is included below which can be used to calculate the financial gearing of a company using the first formula (debt/equity).