Alright everyone, today we’re going to talk about something called the gearing ratio. Now, that might sound a bit technical, but don’t worry, it’s actually quite straightforward once you understand the idea behind it.
Gearing is all about how a business finances itself. In other words, how much of the company’s money comes from borrowing, like bank loans, compared to how much comes from the owners or shareholders. If a company has borrowed a lot of money, it’s said to be highly geared. If it relies mostly on money from shareholders and not much borrowing, it’s low geared.
So why does gearing matter? Well, it tells us about the financial risk of a business. A company that has taken on a lot of loans has to make regular interest payments. Those payments are fixed costs, which means the company must pay them no matter how much profit it makes. During good times, that might not be a problem, but if sales fall or the economy slows down, a highly geared company might struggle to keep up with those payments. On the other hand, a business with low gearing is more flexible and safer in tough times because it doesn’t owe as much money.
Now, let’s look at how we calculate the gearing ratio. The formula is simple. You take the company’s non-current liabilities, which means long-term debts like bank loans or debentures, and divide that by the capital employed. Capital employed is the total of long-term debt plus shareholders’ equity, which includes things like share capital and retained earnings. Then you multiply by 100 to get a percentage.
Let’s do an example. Imagine a company has long-term debt of four hundred thousand dollars and shareholders’ equity of six hundred thousand dollars. That means total capital employed is one million dollars. So, four hundred thousand divided by one million gives us forty percent. That tells us forty percent of the business is financed through borrowing.
Now how do we interpret that? Generally, if gearing is below twenty-five percent, it’s considered low. Between twenty-five and fifty percent is moderate, and above fifty percent is high. A highly geared company, say one with more than fifty percent, faces higher financial risk. They have to pay more interest and could struggle if profits fall or interest rates rise. However, when times are good, they can earn higher returns because they’re using borrowed money to grow faster.
On the other hand, a company with low gearing is financially safer and has more flexibility. But being too low geared isn’t always good either. It could mean the business isn’t taking advantage of borrowing, which can be useful for growth, especially since interest costs can be tax-deductible.
So, how can a business improve its gearing position? If a company is highly geared and wants to reduce its risk, it could repay some of its debts using retained profits. It could also issue new shares to bring in more equity. Another way is to convert debt into shares, known as convertibles.
But sometimes, a business might actually want to increase its gearing, especially if interest rates are low and it wants to expand. In that case, it might take on more long-term loans while keeping its equity level the same.
Let’s look at a quick example. Suppose a company has sixty percent gearing, which is quite high. If it uses two hundred thousand dollars of its retained earnings to pay off part of its debt, its long-term debt falls to two hundred thousand and equity increases to eight hundred thousand. That brings the gearing ratio down to twenty percent, which means the business is now financially stronger and less risky.
Gearing is important to different people for different reasons. Investors look at it to judge how risky a business is before they invest. Lenders use it to decide whether a company can afford to take on more loans. Managers look at it to plan how to finance growth, and shareholders consider it when deciding whether the company can afford to pay dividends.
To wrap up, the gearing ratio is a key indicator of financial risk and stability. Some level of debt can help a business grow faster, but too much can be dangerous if conditions change. The best approach is to find a balance that fits the company’s size, industry, and goals.
By the end of this lesson, you should understand what gearing means, how to calculate the gearing ratio, what high and low gearing indicate, and how businesses can manage their gearing to stay financially healthy.
