What is Gearing?
Gearing is the amount of debt that a company uses to fund its operations in proportion to equity capital. A company that possesses a high gearing ratio shows a high debt to equity ratio, which increases the risk of failure of the business.
Gearing serves as a measure of the extent to which a company funds its operations using money borrowed from lenders versus money sourced from the company’s shareholders. The appropriate level of gearing depends on the industry that a company operates in and the degree of gearing employed by other comparable firms.
Several gearing ratios exist that compare the owner’s equity to the funds borrowed by the company to measure their level of risk. The best-known gearing ratios include:
- Debt to equity ratio
- Equity ratio
- Debt to capital ratio
- Debt service ratio
- Debt to shareholder’s funds ratio
When a company possesses a high gearing ratio, it indicates that a company’s leverage is high, and therefore, susceptible to any downturns that occur in the economy. Similarly, a company with a low gearing ratio enjoys a low debt to equity ratio and relies more on the shareholder’s equity to finance its operations.
Gearing Ratio and Risk
The degree of gearing, whether low or high, determines the level of risk that a company faces. A highly geared company is more susceptible to economic downturns and faces the risk of failure. It is because the company needs to continue serving its debts and paying interest to its lenders, even when the economy is facing a downturn. It means that with the limited cash flows that the company is getting, it must meet its internal operations costs such as utility charges and staff salaries, as well as pay back debts. The company may frequently experience a shortfall in cash flows and fail to pay the equity shareholders and even its creditors.
Also, a low gearing ratio may not always mean that the business’s capital structure is healthy. Capital intensive firms and firms that are highly cyclical may not be able to finance their operations from shareholder equity only. At one point, they will need to obtain financing from other sources in order to continue with their operations normally. In the absence of debt financing, the businesses may be unable to fund most of their operations and pay internal costs.
A business that does not use debt capital misses out on cheaper forms of capital, increased profits and more investor interest. For example, companies in the agricultural industry are affected by seasonal demands for their products and will, therefore, need to borrow funds to meet their arising obligations.
Uses of Gearing
Lenders use gearing ratios to determine whether to extend credit or not. Lenders are in the business of generating interest income by lending out to companies in the short term and long term. Therefore, the lender will consider the gearing ratios of its clients to determine if they will be able to pay back the amount loaned to them.
For example, a startup company with a high gearing ratio faces a higher risk of failing, and most lenders would prefer to stay away from such clients. However, monopolistic companies like utility and energy firms often operate with higher debt levels due to their strong industry position, and lenders would willingly lend to them.
Investors use gearing ratios to determine whether a certain business is a viable investment. Companies with a strong balance sheet and low gearing ratios attract investors who are looking to invest and earn a reasonable interest at the end of the period. However, investors view companies with a high gearing ratio as too risky since such businesses face the risk of bankruptcy if they cannot pay their lenders on time.
A highly geared firm is already paying a high interest to its lenders and new investors may be reluctant to invest their money, since the business may not be able to pay back the money.
Gearing ratios are also used as a comparison tool to determine the performance of one company vis-à-vis another company in the same industry. When used as a standalone calculation, the gearing ratio may not mean a lot of compared to when it is measured against another firm’s ratio. For example, a company with a gearing ratio of 60% may be perceived as a high-risk portfolio, but when the company’s main competitor shows a 70% gearing ratio against an industry average of 80%, the company with 60% ratio is, in essence, performing optimally in that industry.
Financial Modeling Example
Below is a screenshot from CFI’s leveraged buyout (LBO) modeling course, in-which a private equity firm uses significant leverage (gearing) to enhance the internal rate of return (IRR) to equity investors.
Companies and Financial Gearing
There are several instances when a company may engage in financial gearing to strengthen its capital structure, including:
Raise funds without diluting ownership
When sourcing for new capital to support the company’s operations, a business enjoys the option of choosing between debt and equity capital. However, most owners prefer debt capital over equity since issuing more stocks will dilute their ownership stakes in the company and reduce the amount of power that they enjoy as majority shareholders. A profitable company can use borrowed funds to generate more revenues and use the returns to service the debt, without affecting the ownership structure.
A company that mainly relies on equity capital to finance operations throughout the year may experience cash shortfalls that may affect the normal operations of the company. The best remedy for such situation is to seek additional cash from lenders to finance the operations. Debt capital is readily available from financial institutions and investors as long as the company’s books are in order.
A company may require a large amount of capital within a short duration to finance major investments such as to acquire a competitor firm or purchase the essential assets of a firm that is exiting the market. Such investments require urgent action, and the shareholders may not be in a position to raise the required capital due to the time limitations. However, if the business is in good terms with its creditors, it may obtain large amounts of capital within a short duration as long as it meets the requirements set by creditors.
CFI is the official provider of the Financial Modeling and Valuation Analyst (FMVA) certification program designed to transform anyone into a world-class financial analyst. To keep learning and developing your knowledge of financial analysis, we highly recommend the additional resources below: