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The gearing ratio helps us assess how much financial leverage a company has. This important financial metric displays the ratio of a company’s debt and equity capital. This ratio shows how much debt or equity is used to fund a business’s operations.

Investors and analysts can better understand a company’s financial position and its ability to repay its debts by examining its gearing ratio. Lenders and investors often use this ratio to evaluate a company’s credit-worthiness and its ability to repay debts in the future.

In this regard, the credit-worthiness and general financial stability of a company is significantly affected by its gearing ratio.

Let us discuss this ratio in detail:

What is gearing ratio?

The gearing ratio or leverage ratio assesses how much financial leverage a corporation has. By examining the percentage of debt and equity funding, it is used to evaluate a company’s long-term solvency.

In other words, this ratio shows the ratio of a company’s debt and equity or money raised from shareholders. It shows how much of a company’s activities are financed by external debt and is given as a percentage or ratio.

FORMULA

One financial statistic used to assess a company’s level of financial leverage is the net gearing ratio. It compares the total amount of debt – including bank overdrafts and long-term and short-term loans – with the total amount of shareholders’ equity.

The formula is:

Net Gearing Ratio = (Long-term debt + Short-term debt + Bank overdraft) / Shareholders’ Equity

Calculation Example

Let us understand this ratio calculation with an example-

Suppose the financial position of company ABC is as follows-

Total Loan: Rs. 500,000

Shareholders’ Equity: Rs. 1,000,000

Thus, ratio = 500000/1000000 = 0.5

Explanation-

This means that for every Rs 1 of equity, the company has Rs 0.50 of debt. A ratio of 50% indicates a medium level of financial leverage.

What is a good gearing ratio?

A lower ratio indicates that the company is using more equity financing, while a higher ratio indicates that the company is largely dependent on debt financing to finance its operations.

It is widely accepted that an appropriate degree of gearing is better as it indicates harmony between the use of debt and equity financing.

A ratio of more than fifty percent indicates that the company has a higher debt burden than its equity.

Given the company’s propensity for loan defaults and bankruptcy, especially during times of recession or high interest rates, this is often considered a high-risk position.

A higher ratio suggests that the company needs to borrow a large amount of money to continue its operations, which could put further pressure on its cash flow.

What are its uses? gearing ratio?

Some of the uses of this ratio are as follows-

1. By lenders

An essential figure used by lenders to assess the credit-worthiness of a company is the gearing ratio.

As we discussed above, a high ratio can indicate a higher default risk, which can make it harder for a business to obtain funding or good loan terms. Conversely, a low ratio indicates a lower default risk, which can attract lenders and creditors to the corporation.

2. By investors

By indicating a company’s leverage, this ratio helps analysts and investors evaluate the financial risk associated with it.

A high ratio indicates that the organization has a substantial debt burden compared to its equity, therefore increasing its financial risk and sensitivity to fluctuations in interest rates. Macroeconomic circumstances.

Conversely, a lower ratio indicates a financial structure that is less dependent on debt financing and is more prudent.

3. Comparison Tool

This ratio is helpful when comparing businesses in the same sector or industry.

Comparing organisations can reveal which organisations are more or less indebted than their counterparts, as similar operations and revenue streams should result in similar gearing ratios

4. Planning the capital structure

An important tool for businesses to consider when arranging their capital structure. This ratio can be used to evaluate the effects of a business issuing more shares or taking on more debt.

A business can create a capital structure that strikes a balance between its demand for funding and its tolerance for financial risk by examining various conditions and seeing how they affect the ratio.

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Frequently Asked Questions (FAQ)

conclusion

An important financial indicator to assess the financial health of a company is the gearing ratio. It provides practical information about the proportion of equity and debt in a company’s capital structure. Debt financing is a way for a business to raise funds for growth and expansion. The amount of debt a business can take without any risk is determined by the gearing ratio. Tax deductions for loan interest can reduce an organization’s after-tax profit and tax liability.