What is financial gearing?
Financial gearing, frequently called gearing, refers to the relationship of a company’s debt and equity, indicating how much funding a company acquires respectively through debt and equity.
Differently put, gearing is an indication of a company’s financial leverage, revealing the extent to which a business’s operations are funded by lenders (banks and other financial institutions) and owners (shareholders).
Gearing ratios
There are various gearing ratios that can be utilised to calculate the financial leverage of a business, measuring its level of financial risk. Well-known gearing ratios that are useful in financial analyses include, inter alia, debt-to-equity ratio, equity ratio, debt-to-capital ratio, debt ratio, and long-term debt-to-total-assets ratio.
Debt-to-equity ratio (D/E) ratio
Possibly, the most common financial gearing ratio is the debt-to-equity ratio, also referred to as the risk ratio, debt-equity ratio, or gearing ratio.
The purpose of this ratio is to determine the weight of a company’s total debt against its shareholders’ equity, indicating whether a company’s shareholders (owners) equity will cover all its outstanding debt when it is considered necessary.
Formula
Debt-to-equity ratio = Total debt/Shareholders’ equity
Where:
- Total debt includes:
- short-term debt, also called current liabilities, such as accounts payable and short-term loans, that are considered to be paid off within a year,
- long-term debt (comprising, inter alia, bonds, and lease contracts) refers to outstanding debt of a company that has a maturity of a year or longer, and
- fixed payment obligations such as interest expenses, mortgage payments, and lease payments.
- Shareholders’ equity comprises ordinary shares and preference shares. However, some analysts exclude preference shares in the calculation.
Typically, the debt-to-equity ratio is converted to a percentage by multiplying the fraction by 100.
Example
The following figures are obtained from the balance sheet of the company Well Done.
- Shareholders’ equity: R 7 000 000
- Current liabilities: R 1 500 000
- Long-term debt obligations: R 2 400 000
- Fixed payment obligations: R 1 000 000
The D/E ratio of company Well Done will be calculated as follows:
D/E ratio = (R 1 500 000 + R2 400 000 + R1 000 000)/R7 000 000
= R4 900 000/R7 000 000
= 0.70 (expressed as a decimal)
= 70% (expressed as a percentage)
The debt-to-equity ratio of 0.70 shows that for every one South African rand (ZAR) in equity, company Well Done has 70 cents in leverage. Put differently, lenders and creditors provide 70 cents for each South African rand (ZAR) provided by shareholders to finance the operations of Well Done.
Equity ratio
The equity ratio also called net worth-to-assets ratio or shareholder equity ratio, compares a company’s total assets to its total amount of equity, indicating the relative amount of equity utilised to obtain assets of the company.
The equity ratio is an indication of a company’s financial strength, where a higher ratio is evidence of a company’s healthy long-term solvency situation.
Formula
Equity ratio = Total equity/Total assets
Where:
- Total equity is also referred to as shareholders’ funds.
Example
Company QED has shareholders’ funds of R650 000 and total assets of R820 000.
The company’s equity ratio will look as follows:
Equity ratio = R650 000/R820 000
= 0.79 (expressed as a decimal)
= 79% (expressed as a percentage)
The result of 79% indicates that company QED has acquired 79% of its assets with equity.
Debt-to-capital ratio
The debt-to-capital ratio is a liquidity ratio that measures a company’s financial leverage, comparing its total debt obligations to its total capital.
Put in other words, the debt-to-capital ratio measures the percentage of debt a company uses to fund its daily operations as compared with its capital.
Normally, the higher the debt-to-capital ratio, the more a company is exposed to credit risk, incurring the risk to default on some or all of its debt obligations.
Formula
Debt-to-capital ratio = Total debt/Total capital
Where:
- Total debt is the sum of all the interest-bearing debt, such as bonds, long-term liabilities, and short-term loans.
- Total capital includes:
- total debt, and
- shareholders’ equity, comprising ordinary shares, preference shares, and minority interest.
Example
Company Rise & Shine reported, among others, the following figures on its balance sheet for the past financial year:
- Preference shares: R1 500 000
- Minority interest: R500 000
- Outstanding ordinary shares: R10 000 000
- Interest bearing short-term and long-term loans: R 2 500 000 and R6 000 000
- Accounts payable (interest-free): R90 000
- Bonds payable (interest-bearing): R2 000 000
The debt-to-capital ratio of Rise & Shine is determined as follows:
Debt-to-capital ratio = (R2 500 000 + R6 000 000 + R2 000 000)/ ((R2 500 000 + R6 000 000 + R2 000 000) + (R1 500 000 + R500 000 + R10 000 000))
= R10 500 000/ ((R10 500 000) + (R12 000 000)
= R10 500 000/R22 500 000)
= 46.67%
The result of 46.67% shows that the company Rise & Shine utilises 46.67% of its debt and 53.3% of its capital to fund its business operations.
Debt ratio
The debt ratio, also called the total debt ratio, is a financial ratio used in accounting to indicate what portion of a company’s assets is financed through debt.
A high debt ratio of higher than 0.5 or 50% is an indication that a company is ‘highly leveraged,’ meaning that most of its assets are financed through debt.
Formula
Debt ratio = Total debt/Total assets
Where:
- Total debt includes short-term debt, as well as long-term liabilities.
- Total assets comprise current assets, fixed (long-term) assets, and intangible assets, such as goodwill and trademarks.
Example
Company Perseverance reported on its latest balance sheet, among others, the following figures:
- Total of short-term liabilities: R 1 500 000
- Total of long-term debt obligations: R3 700 000
- Current assets: R2 600 000
- Fixed assets: R5 000 000
- Intangible assets: R2 000 000
The debt ratio of company Perseverance will be calculated in the following way:
Debt ratio = (R1 500 000 + R3 700 000)/ (R2 600 000 + R5 000 000 + R2 000 000)
= R5 200 000/R9 600 000
= 0.54 (expressed as a decimal)
= 54% (expressed as a percentage)
Company Perseverance’s debt ratio shows that its assets are highly leveraged, acquiring most of its assets with debt.
Long-term debt-to-total-assets ratio
The long-term debt-to-total assets ratio is a measurement that indicates the portion of a company’s assets financed with long-term debt, which includes loans and other debt obligations that mature in more than one year.
This ratio is useful when analysing the long-term financial position of a company.
Formula
Long-term debt-to-total assets ratio = Long-term debt/Assets
The difference between the long-term debt-to-total assets ratio and the debt ratio is that short-term debt is excluded in the calculation of the first-mentioned ratio.
Example
Company Long Last has long-term debt obligations of R4 200 000 and total assets of R9 000 000, providing the following long-term debt-to-total assets ratio:
R4 200 000/R9 000 000
= 0.47 (expressed as a decimal)
= 47% (expressed as a percentage)
The ratio of 0.47 is lower than 0.5, which is generally considered good, meaning that the company Long Last has R0.47 as a long-term debt for every South African rand (ZAR) it has in assets.
In other words, company Long Last will be required to liquidate 47% of its assets to repay its long-term debt.
Some basic guidelines when using gearing ratios
- When analysing and comparing gearing ratios, make sure that companies of similar business, operating in the same industries, are compared.
- A bad or good gearing ratio is totally relative because it is a comparison between an individual company and similar companies in the same industry.
- Although entirely relative, the following general rules can be applied to distinguish between acceptable and unacceptable gearing ratios:
- High gearing ratios exceed 50%.
- A low gearing ratio is usually below 25%.
- Optimal gearing ratios vary between 25% and 50%.
- When the proportion of a company’s debt-to-equity is high, the company is considered as highly geared, or highly leveraged.
- Usually, a higher gearing ratio indicates a higher financial risk to stakeholders such as lenders, creditors, and shareholders.
- Obtaining debt is not a bad thing per se, depending on how a company manages its debt. Additional funds from loans can enable businesses to expand and improve their operations and to enter new markets, improving profitability in the long term.
- Contrarily, a company with an exceptionally low gearing ratio could not seize opportunities to expand when interest rates are low. Hence, the company could be deprived of growing and profit-making opportunities.
Ways of reducing financial gearing
A company can reduce its financial gearing by paying off some or all of its debt. This can be done in different ways:
- Distributing shares
Funds to pay off debt can be obtained by selling more shares to the public. This will increase the company’s equity and decrease its debt.
- Decreasing operational expenses
Saving on unnecessary costs regarding operations can enable a company to have more cash available to pay off debt.
- Increasing profits
Creative strategies to improve its profits can allow a company to generate more cash that can be used to pay debts.
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